At&T: Will The Bad News Ever End?

The telephone giant is stumbling--just when it faces the fight of its life

Has AT&T Corp. Chairman Robert E. Allen finally used up all his second chances? After eight years of downsizing, reorganizing, reorienting, and restaffing the telephone giant--and after just as many surprise setbacks and strategy shifts--his Sept. 24 bombshell was, to many, the last straw. "You wonder if management really has the ability to take it to the next level," says Hersh Cohen, manager of the Smith Barney Appreciation Fund, which holds about 1 million AT&T shares. "I've been a big booster, but I've got to reevaluate everything here."

That the phone giant's problems may be growing beyond the grasp of the current management was made dramatically clear on the 24th. Having initiated a bold "trivestiture" a year ago--to spin off the phone-equipment and computer businesses so AT&T could focus solely on telecommunications services--here was Allen suddenly disclosing that the company is unable to hold its own even in its core long-distance business. That morning, Allen announced the company's earnings will come in some 10% below what analysts had been led to expect--both in the third quarter and the fourth.

News of the shortfall was bad enough. But it comes after years of unfulfilled promises and just weeks after the jolting news that AT&T's president and heir apparent, Alex J. Mandl, was leaving to head a virtually unknown wireless startup. Worst of all, it reveals the harsh new realities of the long-distance business.

After a poor showing in the second quarter, when AT&T admitted to being blindsided by a pack of feisty small competitors, Allen's team had been promising a comeback in the second half. Their efforts--including mailing some $1.5 billion in checks to pay consumers to switch to AT&T--did not pan out. To halt its slide, it will now forget about charging a premium for its brand and fight the competition on price. AT&T will offer a 15 cents-a-minute flat-rate service 24 hours a day--a response to Sprint Corp.'s popular 10 cents-a-minute program, which is limited to off-hours.

As analysts scaled back earnings estimates for the rest of this year and all of next and downgraded their ratings, AT&T shares tumbled 5 5/8 points, to $51.50. And confidence in Allen's leadership sank with them. "The market is saying we definitely have no confidence," says Morgan Stanley & Co. analyst Stephanie Comfort. "The investment community has definitely thrown in the towel."

Allen, 61, insists he is not about to throw in the towel--nor has AT&T reached a crisis that would force him out. "I have no plans to retire at this time," Allen told BUSINESS WEEK. "The board is not asking me to leave." Indeed, for all the bad news, AT&T is still financially strong: Post-divestiture, it has some $8 billion in annual cash flow, $56 billion in assets, and $8.5 billion in long-term debt. Furthermore, despite the Sept. shocker, Merrill Lynch & Co. still expects the company to show profits of $5.6 billion on $51.4 billion in revenue in 1996, a slight gain.

Still, the issue of Allen's tenure won't go away. During a closed-circuit TV broadcast to employees on the 24th, the CEO volunteered--without being asked--that he was not about to resign or retire. That didn't stop the hallway chatter, though. "There's a lot of noise about his moving on," says a midlevel employee. With the loss of Mandl and the upheaval as the trivestiture cuts 7,000 jobs, employee morale--and esteem for the boss--are ebbing. "The morale problem has never been as bad as in the last six months," says a consultant to AT&T. "The employees I talk to feel completely overwhelmed."

No wonder. In Allen's eight years at the helm, the company has spent a total of $20 billion on acquisitions and absorbed $19 billion in restructuring charges in an effort to remake itself--with little to show for it. Since 1993, AT&T's stock, like that of many other phone companies, has lagged the Standard & Poor's 500-stock index by some 30%. But since January, AT&T's stock has done much worse, dropping 20%.

At the same time, with the help of legions of consultants crawling over the company, Allen has tried a host of different strategies. He paid $7.5 billion for NCR Corp. to restart AT&T's failing computer operation, then racked up some $2.6 billion in losses in that business before deciding to get out of computers altogether. AT&T funded and then abandoned startups in handheld computers and software. It launched, then killed, proprietary online services. It started, then tabled, Internet content efforts. Even AT&T's fast-growing Universal credit card is being overhauled because of high default rates. Its president, David K. Hunt, resigned on Sept. 4. "Any observer has to conclude that their strategy over the last four or five years has been kind of ad hoc," says John Sidgmore, president of MFS Communications.

AT&T can no longer afford such costly missteps. Its new calling plan only confirms what competitors have been proving: Long-distance service is becoming a cost-sensitive, commodity-like business. "AT&T has stayed too long at a high-end price position," says Probe Research Inc. consultant Alan Tumolillo.

Now, Allen is in a real bind. He's caught fighting a price war to defend his long-distance business just when he needs to launch the strategies the company must have in place to survive in a new world of deregulated phone markets and new high-tech communications. And suddenly, the earnings from today's business that he's counting on to fund the future are in jeopardy. "AT&T's ability to move into other areas depends on a healthy core business, and their core business is not healthy right now," says Jeffrey A. Kagan, president of Kagan Telecom Associates, a consulting firm.

This is where AT&T runs into the kind of management quagmire that you might call the IBM problem. Just as IBM was caught between perpetuating its dominance in mainframes and pushing forcefully into faster-growing new markets such as personal computers, AT&T is faced with the question of how to move beyond long distance. So far, AT&T has been spared a technology threat to its basic business--the way IBM had to cope with the new economics imposed on computers by the microprocessor. But that, too, could be coming--from the Internet, where thousands of people are already making phone calls and sending faxes without paying long-distance charges.

Certainly in terms of managing its business, Allen has been struggling with IBM-like issues for years: How do you get a huge bureaucracy, accustomed to fat margins and a dominant role in its core business, to move as quickly as, say, a Microsoft? "They have a real challenge now, trying to hold on to market share while growing in new services," says Gordon J. Bridge, who has worked for both IBM and AT&T, where he was vice-president for strategy before leaving a year ago to take over Connect Inc., an Internet services company. "It's like patting your head and rubbing your stomach at the same time."

Succession, then, has become the key management issue at AT&T--even for Allen. "My primary interest is the future leadership of AT&T," Allen says. That's why he's floating the idea that, instead of simply replacing Mandl and continuing on as CEO until his retirement in 2000, he would be willing to step aside--if that's what it takes to get the right recruit. "If we find God, or something short of that, and the conditions seem right for Bob Allen to have some transition period out over some period of time, I don't have any problem with that," he told BUSINESS WEEK in mid-September.

The signs that Allen won't insist on staying make recruiting a top gun easier. The headhunters aren't talking, but rumored candidates range from George Fischer of Eastman Kodak Co. to John Whiteside, head of IBM's network business. Both deny any interest. Now that Allen hints that he might go, "it changes the dynamics of the search," says Gerard R. Roche, president of executive-search firm Heidrick & Struggles, which is not involved in the hunt. "I think they'll have no problem getting a healthy array of candidates. They may not get the water-walkers that they want, but it does present an outstanding opportunity."

Miracle workers may not be required, but a strong outsider with a fresh take on AT&T's problems--a Lou Gerstner--would do nicely. If Allen doesn't find one on his own, how long will his board give him? So far, the directors are standing by their man. But Allen can't count on that allegiance indefinitely. If it comes down to sticking by Allen or recruiting the new leadership that would get shareholders off its back, AT&T's board might try what AlliedSignal Corp.'s directors did in 1991. Like Allen, Chairman Edward L. Hennessy Jr. planned to hang on for at least two years to groom his successor. But the top candidate, Lawrence A. Bossidy, then vice-chairman of General Electric Co., refused the job unless he could take over immediately. Allied's board backed Bossidy, and Hennessy was out.

However it happens, long before Allen's scheduled retirement in 2000 AT&T needs a boss with talents that the current CEO lacks. At a time when digital technologies are remaking communications, he's no techno-visionary. And when it's crucial to rally 125,000 employees and skeptical investors around a clear strategy, Allen is anything but a great communicator. He concedes as much: Mandl's replacement, he says, must be a person "who can communicate with our people, clarify direction so we can get out in front--someone who can really charge people up."

They'll have to be charged up to cope with what AT&T has on its plate. As deregulation spreads around the world, the walls between local and long-distance service, voice and data calling, cable and broadcast TV, and wired and wireless are crumbling. The new rules are bringing new players into the market and allowing existing ones to team up in awesome combinations. Once Congress passed the bill deregulating U.S. telecom markets last February, dealmakers began engineering two massive mergers--one between Bell Atlantic and Nynex, the other between Pacific Telesis and SBC Communications--that will turn four Baby Bells into two mega-Bells. And with the pending merger of WorldCom Inc. and MFS Communications, AT&T suddenly faces a third important rival in long distance, one that can already sell a combination of local calling, long distance, and Internet services.

Allen promises that in the next few weeks he will raise the curtain on more initiatives--in addition to the 15 cents plan--that will dispel the impression that AT&T has fallen behind. "We haven't spoken in a clear fashion with investors in recent months," he admits. Allen has scheduled a meeting with analysts for Nov. 19 and says he plans more such briefings.

The CEO says he had to keep quiet about AT&T's all-important scheme for local calling until the Federal Communications Commission issued rules on Aug. 8 that clarify how local phone companies must deal with competitors. Those rules, Allen says, now let AT&T jump into local service in a less costly way. The company plans to start its first local trials in October in California and Connecticut, initially by reselling service leased from a combination of local phone companies and private-line competitors. By yearend, AT&T plans to also start trials in Illinois, again through reselling initially.

That's only part of a more sweeping strategy for the converging voice, data, and video communications industry. This new megamarket presents AT&T with the fight--and opportunity--of its life. If it plays its hand right and grabs a healthy chunk of this $500 billion-a-year business, the continuing erosion of its 56% share of the $76 billion U.S. long-distance market won't matter in the end. In fact, Morgan Stanley's Comfort estimates that AT&T's percentage share of long-distance calls will drift down to the low 30s in 10 years--but it will make up for that by winning 15% to 20% of the much larger local-calling market. "We could easily double our revenues in this new market and still be a relatively low-share player," figures Jospeh P. Nacchio, head of AT&T's consumer calling business.

To pull it off, AT&T will have to think like a high-tech growth company, rather than the monopoly it was. Despite the influx--and departure--of outside recruits that Allen brought in to run everything from computers to credit cards (table), the old AT&T mind-set seems to hold sway. The company still harbors a grandiose view of its prospects in new markets, in the same way IBM once assumed that its strength in mainframes entitled it to huge chunks of adjacent markets. Take Allen's boast in June that AT&T will take one-third of the local-calling market in a few years. "I would never say that," says the CEO of another long-distance company. "That's just plain arrogance."

Sure, analysts agree that AT&T has a better chance than any other newcomer in the $90 billion local-calling market. But nobody is going to walk onto Baby Bell turf and steal customers without waging an expensive fight. The Bells, in fact, will have a far cheaper task going after long-distance customers, because they won't have to build their own networks: There is plenty of excess long-distance capacity for sale.

AT&T's one unquestioned asset--its gold-plated name--may prove its most important weapon in the new telecom market. In communications, no brand is more recognized than AT&T's, not least because it spends some $700 million a year on advertising to keep it before the public. The brand is the cornerstone of AT&T's strategy to sell "bundles" of products such as local and long-distance calling, wireless service, and Internet access. Even before such packages are available, in surveys consumers choose AT&T more than any other phone company for all their communications needs.

And there's little doubt that bundles will sell. According to a survey conducted in August by Yankee Group, 67% of households say they are interested in one-stop shopping for all electronic communications. That's a huge opportunity: Yankee figures that currently, AT&T customers spend an average of $27 per month on long-distance calling and $100 to $200 a month on all their electronic communication needs: telephony, cable TV, online services, cellular, and paging. With bundling, AT&T aims to get all, or at least most, of that monthly bill.

AT&T has been furiously assembling the pieces of its bundle for the past two years, starting with the purchase in September, 1994, of McCaw Cellular Communications Inc., the largest cellular-phone operator in the country. Last year AT&T paid $1.7 billion for licenses to operate personal communications systems in 23 regions across the U.S., making it one of the biggest players in this new form of wireless calling. AT&T is also inching into video with its 2.5% stake in Hughes Electronics Corp.'s DirectTV satellite service, which it's marketing to AT&T phone customers. With 400,000 customers using its WorldNet service, AT&T has also become the No.2 Internet-access provider after Netcom On-Line Communication Services Inc. "They have all the pieces of the puzzle," says UBS Securities Inc. analyst Linda B. Meltzer. But, she asks, can they put them together?

Allen knows AT&T has a long way to go to answer that question. "Our challenge in the next two to three years is execution," he says. The company's initial attempts aren't encouraging. AT&T shot itself in the foot by failing to complete a computer system to bill customers for a variety of services. "I could have had bundles out months ago," Nacchio claims. But he had to wait for the programmers to finish--months behind schedule. "We have to be careful not to rush out bundles in a way that would hurt our reputation," he says.

Indeed, nobody wants a rerun of AT&T's image-tarnishing leap into the consumer Internet-access business last February. The company was totally unprepared to deal with the surge of demand for sign-up disks for WorldNet when AT&T offered five free hours a month of cybercruising or unlimited online use for $19.95. The company didn't have enough people to answer the customer calls, leaving potential subscribers frustrated. "They rushed WorldNet to market and they weren't prepared," says telecom consultant Kagan. "Before, they would have been very, very late but right." Allen won't repeat the mistake. "We learned from that experience," he says. "We may be slower to come to market and offer new services on a broad-scale basis until we're absolutely sure we're able to offer the right customer service."

Still, AT&T can't drag its feet. Every other phone company out there is convinced that bundling is the way to go. MCI Communications Corp. already beat AT&T to the punch by offering a combination long distance/wireless services/Internet-access package to consumers in selected regions in April, followed by a similar offer to business customers in September. AT&T only just announced a similar package for business customers on Sept. 18.

Can AT&T get its bundles together fast enough? It doesn't help that while it's trying to launch this new strategy, it's still in the throes of its trivestiture to spin off its phone-equipment and computer businesses. The equipment business, now called Lucent Technologies Inc., will become independent on Sept. 30; the spin-off of NCR Corp. will be completed by yearend.

The critical element in AT&T's bundling plan--and one that no long-distance company offers--is local calling. Now, thanks to the new FCC rules, AT&T says it is ready to pounce. In August, the agency ruled that local phone companies must "unbundle" their network--and lease each part separately to AT&T or anybody else that wants to compete in the local market. That could cut by 40% or more the $13.5 billion a year AT&T now pays in access charges--the fees for connecting long-distance calls to their final destinations.

Until the new ruling, AT&T was treading slowly in local calling because the only practical way to get in was as a "reseller"--leasing capacity at wholesale rates from the local phone companies and reselling it to customers. This method would allow AT&T only a 17% to 25% discount off retail rates, and it would still pay access fees. But now, the FCC is forcing local carriers to offer each piece of its network separately, including the lines into the home, operator services, and the central switch that completes local calls. "It's as though McDonald's had to unbundle the Big Mac and just supply the burger, while competitors added their own bun and lettuce," says Brian Adamik, a Yankee Group consultant. By leasing parts rather than the whole network, AT&T gets a 35% to 45% discount off retail--and a 30% to 35% discount off access rates. If it provides its own switch, it pays no access charges. "That is very different from plain reselling and a huge advantage for us," says Allen.

Wherever it can, AT&T will use its own switches or those leased from so-called competitive access providers (CAPs) that already compete against the Bells. AT&T has signed contracts with six such CAPs this year, covering 80 cities. AT&T executives also hint that they can use some of the company's 136 long-distance switches already in place, as well as AT&T's national network of cellular switches, to avoid access charges. Stephanie Comfort of Morgan Stanley estimates that long-distance carriers could achieve operating margins on local service of 35% if they install their own switches, compared with the Bells' 20% to 22%.

Of course, as AT&T moves into local, it has to prepare for the arrival of the Baby Bells in long distance. If it can't handle the competition now, how will it cope with the all-out attack of the local phone giants? Analysts figure local phone companies can grab 25% of the long-distance calls in their regions within three years. All of the Big Three long-distance carriers will be hurt, but AT&T, with 70% of residential customers, is the main target. "AT&T is absolutely sure to lose market share, and they know it," says a recently exited AT&T exec.

Not that AT&T is just a sitting duck. Even as it has been losing ground in residential calling, it has been winning business customers, who make up about 40% of its volume. "We are certainly holding and probably gaining market share on the business side," says Allen. It recently won back IBM and Merrill Lynch & Co. from MCI and signed a $2 billion contract with J.P. Morgan & Co. AT&T Solutions, an outsourcing division started a year ago, has won $4.3 billion worth of contracts to operate communications operations for major corporations, including a $1.1 billion, 10-year contract to manage Textron Inc.'s telecom network.

Then there's AT&T Wireless, formerly McCaw. So far, competitors and analysts say, AT&T has done little to exploit the possibilities of cross-marketing its wireless and long-distance service. Until a year ago, AT&T had been barred from doing so. But even without the help, the wireless side is doing all right: Its roster of subscribers jumped by 30%, to 6.25 million, in the second quarter.

But for long-term growth, the company must roll out all-new services and capabilities. Strategy chief John C. Petrillo's goal is to make sure AT&T is in the vanguard of digital convergence, where computer, voice, and video traffic blend on high-speed "broadband" networks. The company's AT&T Labs is working on the "renaissance network"--a high-tech digital system that can support all sorts of futuristic services, such as getting your message to anyone, anywhere, using any form of communications. "You'll be able to reach them by any medium, from fax to E-mail to voice," says Lawrence R. Rabiner, a lab vice-president.

Nice future if you can get it. But 12 years after losing its government-guaranteed monopoly, AT&T is still far from the agile, high-tech powerhouse it aspires to become. "Their infrastructure is filled with people who are not new-product and new-technology people," says a high-tech entrepreneur who once worked with the company. "Giving birth to new technology? That's not where AT&T is." Can AT&T ever get there under Allen? If devotion to the company were enough, perhaps. "I love this company, I love the opportunities I see here," says the man who has spent his entire working life at AT&T. "I love the people here. We have great customers."

Despite all Allen's considerable achievements in bringing AT&T as far as it has come, executives who are close to the company say a new style is badly needed. On the inside, the need to change the mentality is widely acknowledged. "They are working heavily on changing the culture and encouraging more risk-taking," says David A. Nadler, chairman of Delta Consulting Group, who has worked closely with AT&T for a decade. "They are not in denial about the changes that need to be done, the way IBM was."

Which in the end may be what saves AT&T: Everyone knows that if it doesn't change, the bad news will never end. "If I were running that business, I would have a sign on the wall saying, `if we don't manage this business with energy, we'll turn into IBM,"' says Robert M. Kavner, former head of AT&T's multimedia business and now CEO of On Command Corp., which provides TV programming to hotels. Now all Allen needs to do is find a president who can read the sign.

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