The Baby Bells' Painful Adolescence

At first glance, Pacific Telesis Group Chairman and Chief Executive Sam L. Ginn has one of the easiest jobs in Corporate America. What could be simpler than running a big phone company? No style trends to keep up with, no factories to create toxic waste, no competition from cheap imports. Just send out the monthly bills and rake in the cash, right? Indeed, last year, the San Francisco-based Baby Bell made a cool billion dollars in profit on revenue of just under $10 billion. And Ginn, a lanky Alabama native, didn't do too badly himself, with $1.8 million in cash compensation.

But look again. Almost nine years after the regional phone companies were spun off from American Telephone & Telegraph Co. in the 1984 Bell System breakup, Pacific Telesis and its six siblings are feeling queasy. Competition and new technology are crowding into their lucrative monopolies in local phone service. From Australia to Hungary to Britain, their foreign ventures are consuming cash rather than generating it. And shareholders, after enjoying big stock runups and rising dividends in the 1980s, have little patience. They are unhappy that Ginn and other Bell CEOs suddenly want to curb dividend growth and use profits to beef up their networks and diversify at home and abroad. Laments Ginn, 55: "I've been in the industry 30 years, and I have never seen such pressure, such turmoil."

The Bells' problems stem from one fact: They are old companies in a new age. Although they're called babies, they still bear the imprint of Theodore N. Vail, who created the Bell System monopoly in the early 20th century. Unfortunately for the Bells, ponderous monopolies don't work in an era of new technology, high-speed management, and adroitness. The Bell CEOs know they need to change. They're just not sure into what. So, like seven George Bushes, Ginn and his counterparts are groping for the vision thing.

BETTER TO SHARE. The winners will be the companies that carefully focus their energies, work well with partners, and remember that it's better to share in a high-growth competitive industry than to control a slow-growth monopoly. As they concentrate on different areas, the Bells will become noticeably different from each other. They may sell off pieces of their networks or invade one another's territories or split themselves up. And there need not be seven Bells. After all, early divestiture plans called for anywhere from 1 to 22 to 51 of them.

They don't have forever to hone their strategies. Competition for the local telecommunications business is popping up in every quarter, from long-distance carriers who would like to grab the lucrative short-haul tollcall business to cable-television operators and others who think they can beat the Bells in local phone services. On Sept. 17, the Federal Communicaitons Commission took a big step toward ending the monopoly on local service, directing the Bells and other local phone companies to allow rival carriers to use their networks to connect calls to large customers. Competitors compare the move to the FCC's Execunet ruling that let MCI Communications Corp. crack AT&T's long-distance monopoly back in 1974. As the new ruling was announced, FCC Chairman Alfred C. Sikes warned the phone giants that "the quiet life has ended."

Heads are already rolling. In May, Chairman William L. Weiss of Chicago-based Ameritech Corp. ousted four of his highest-ranking officers, all group presidents. He says they were "absolutely first-rate, ethical people in every sense" - but not the kind of forward-looking leaders Ameritech needs now. Weiss, lonelier now at the top, says: "We have only about three to five years to get ready for this. By that time, competition will be like Niagara Falls pouring over the edge."

Whether the Bells can transform themselves is of considerable interest to most Americans. Three out of four live in the Bells' service areas, with the rest served by thousands of local phone companies, including subsidiaries of companies such as GTE Corp. Consumers can choose their brand of car, coffee, or long-distance service, but if their local phone company offers lousy service, they're out of luck. Sure, competition is eating into the revenues of local providers. But it will be years before rival networks are so widespread that customers - even large corporations with the most choices - can afford to be indifferent to the fate of the Baby Bells.

The Bells have been odd hybrids since birth. They were conceived in 1982 as bare-bones owners of local phone companies, but even before their joint birthday on Jan. 1, 1984, they laid plans to diversify into businesses that no phone company had ever been in before. As they toddled into computers and finance, they often stumbled, but growing profits from regulated local phone units created a green carpet of cash that masked any losses. U.S. West tried to build a real estate empire, Nynex ventured into personal-computer retailing and office furniture, Ameritech went into mainframe software, and Southwestern Bell bought a company that does architectural and interior design.

SOUL-SEARCHING. Now, the cash carpet is being yanked away. Competition is driving down rates at the same time that the need for investment in local phone networks is rising. Take Pacific Bell, the regulated California Unit of Sam Ginn's Pacific Telesis. According to an analysis by the Communications Workers of America, the phone employees' union, five years ago, Pacific Bell was paying $556 million more to Pacific Telesis than the parent company needed to pay dividends. By last year, that had dropped to just $35 million more, and CWA analyst Steven Abrecht predicts that the number will turn negative this year. The same is happening at the other Baby Bells.

That is prompting some soul-searching. Some Bell radicals are questioning the very logic of a monolithic local phone company that, in one organization, provides all varieties of phone service to all types of customers. Instead, they see phone companies providing certain core services to partners who specialize in, say, banking by phone or electronic interchange of data.

Opening up the network to these partners could trigger an explosion in network usage and revenue. Why? For the same reason that opening up the original IBM Personal Computer created a whole new industry. As a standard, it permitted the emergence of hundreds of PC-compatible software and hardware products - far beyond what any one supplier could have created - which in turn made the PC more popular.

Such a cycle is ready to occur in telecommunications, reasons one of the mavericks, Doug Bulleit, president of BellSouth Advanced Networks. He hopes that people with new ideas for communications based services will use the public network as a standard platform instead of cobbling together their own private networks. If so, network usage could soar. Says Bulleit: "This looks like the next generation of prosperity."

FRESH THINKING. New services, more usage, more revenue. If that just sounds like common sense, you've never worked in a phone company, where the tradition is to regard every alternate service supplier as a fresh leak in the revenue bucket. Slowly, though, the new way of thinking is catching on, and the Bells are moving toward alliances on everything from medical imaging to pay-per-view television to delivering financial data. BellSouth is cooperating with Dow Jones and Cox Newspapers; U.S. West with cable giant Tele-communications; Nynex with Massachusetts General Hospital. Bell Atlantic Corp. Chairman Raymond W. Smith says picking the right partners will be one of his biggest management challenges for the 1990s.

Pacific Telesis is taking a more dramatic tack because it has more pressing problems. With California's economy going nowhere fast, Telesis' profits have been in a three-year slump. This year's earnings per share are projected at around $2.92, down from $3.02 in 1989. And regulation is getting tougher. The state Public Utilities Commission (PUC), under a new chief, is preparing to let long-distance carriers into the medium-distance toll-call market in California, jeopardizing a highly profitable, 2 billion chunk of Pac Bell's business. The company hopes to make up the loss with massive hikes in monthly fees for home and business lines, but the PUC is unlikely to permit large increases while the recession lingers.

None of this was completely unexpected. But by now, Pacific Telesis had hoped that profits from its foreign ventures would be kicking in, supplementing profits from its fast-growing domestic cellular business, which totaled 114 million last year. No such luck. With the exception of a few operations such as paging in Thailand, foreign operations are still cash drains. In Germany, delays in building handsets postponed by nearly a year the inauguration of service on a digital cellular phone network in which Telesis owns a 26% stake. In a few years, German cellular is likely to be a huge cash-spinner, but so far, Pacific Telesis has gotten little for its 210 million investment.

Sam Ginn is taking arms against this sea of troubles by considering the most dramatic act by any Baby Bell since the Bell System breakup. Last year, Ginn and his board started seriously exploring a voluntary split of Pacific Telesis into two companies - one regulated and one not. The big one, with about 90% of today's revenues, would contain the profitable but slow-growing local-phone operations in California and Nevada. The other, a debt-heavy, billion-dollar Baby Baby Bell, would contain diversified, unregulated businesses - predominantly cellular, paging, and new kinds of wireless services in the U.S. and around the world. A board decision could come as soon as Oct. 23, though director William K. Coblentz says that none of the board members has made up his mind yet.

Ginn figures that both companies would gain new oportunities from a breakup. Alone, the new diversified company could blossom by being allowed to manufacture products and carry long-distance calls - businesses from which today's Pacific Telesis is banned. Meanwhile, adds Ginn, big old Pacific Bell might qualify for new types of wire-less-phone licenses that it's unlikely to get as long as it is under the same roof as PacTel Cellular.

Best of all, Ginn argues, shareholders could choose between pure plays. Dividend seekers would stick with Pacific Bell, while go-getters would keep their shares in a diversified company that could go on a spending jag by issuing loads of new debt and equity. As things stand, Ginn says, PacTel might have to pass up once-in-a-lifetime investment opportunities in order to preserve its credit rating and dividend. Investors expect no less, since Pacific Telesis has raised the dividend faithfully evey year since divestiture. Says Ginn: "We've created this dilemma through our own success."

Break up voluntarily? Most Bells are moving in the other direction. South-western Bell Corp. flattened its organization this year so that different components of the telephone company report directly to Chairman Edward E. Whitacre Jr. instead of to a separate telephone-unit president. A breakup of Telesis would wipe out all the opportunities for synergy between old and new businesses that Pacific Telesis and its siblings have made so much of since 1984. The new diversified company might be so much smaller that it would disappear from the dealmaking radar screen-even though Robert L. Barada, PacTel's vice-president for corporate strategy, says it would be "the strongest capitalized cellular business in the world."

As dramatic as its breakup scenario seems, though, the biggest flaw in Telesis' plan is that it might not make much difference. It would leave Pacific Bell - the fast bulk of today's corporation - essentially unchanged. Indeed, Ameritech's Weiss says that of the many ideas being thrown around by the seven Bells for reshaping themselves, subdividing represents "the least change of all."

RESIDUE. What, then would constitute real change? Transforming the monopoly service mentality that continues to pervade all seven Bells - a residue of the prebreakup days that clings even to parts of the organizations born since divestiture. Says Richard A. Kuehn, a Cleveland-based telecommunications consultant: "While they're talking a reasonable story, their commitment to meeting the customer's agenda is not a prime target in their mind."

Kuehn knows where-of he speaks. Four years ago, he was trying to help a new hospital in Pleasanton, Calif., get a service from Pacific Bell called Integrated Services Digital Network to improve data links with doctors' offices. After being stalled for five months, he was invited to the West Coast for dinner with a Pac Bell vice-president. Satisfaction seemed at hand. But before his seat was warm, the vice-president turned him down flat. Says Kuehn: "I really would have liked to pick up my drink, spill it in his lap, and walk out." Pac Bell, which has since made ISDN more available, says Kuehn wanted the service free on a trial basis - a charge Kuehn denies.

While customers blame the Bells for unresponsiveness, the Bells blame regulators for giving them little incentive to invest in phone networks. William H. Davidson, a professor at the University of Southern California School of Business Administration, says U.S. phone companies have to stretch out the depreciation of their digital switches over an average of 17 1/2 years, vs. 6 years in Japan. That makes it harder for U.S. phone companies to modernize. And as public utilities, they are also expected to invest whatever it takes to restore phone service quickly in case of disaster, as BellSouth did in Florida, where it dispatched 900 extra technicians in the wake of Hurrican Andrew.

Eventually, the threat of competition should be all that's required to lower the Bells' rates and keep them investing in their networks. But as long as local phone service remains close to a monopoly, regulators, judges, and lawmakers will wield enormous power. In the weeks preceding the FCC's momentous Sept. 17 rulings, so many titans of the telecommunications industry converged on the agency one day to plead their cases that the agency ran out of visitors' badges. Says G. Mitchell Wilk, former head of California's PUC: "Government has more to say about the profitability of this industry than it ever has."

Which is why the Bells are working harder than ever to uncover new opportunities - to find a new game plan that's bold, visionary, and might actually make some money. They're saying no to furniture and real estate, but they're saying yes to selected foreign phone investments. With experience in the world's most demanding phone market, the Bells feel they can help beef up systems abroad. Thus, Bell Atlantic and Ameritech now own 75% of New Zealand's phone company. Nynex and a Thai partner will build a new phone network in Thailand and operate it for 25 years. BellSouth belongs to a consortium in Australia that aims to compete against the established local carrier. Pacific Telesis and BellSouth are concentrating on international opportunities in wireless. And U.S. West is focusing on cable-television opportunities abroad.

By far the biggest winner of that game to date is Southwestern Bell, which struck it rich purchasing a 10% interest in Telefonos de Mexico. Since buying the Telmex shares for $953 million, Southwestern Bell has earned a paper profit of more than $1.5 billion.

Back home, Baby Bell bosses have come to see that they can generate a lot more revenue from their core local phone businesses. After all, cost-cutting can go only so far. Pacific Bell, for example, has cut employment from nearly 79,000 at divestiture to about 54,000 now. Advances in technology should allow further trims, but the paring could go too deep: The Bells could be left vulnerable to the predations of their emerging competitors.

That's why top-line growth is essential. Facsimile machines, cellular phones, answering machines, and voice mail have all increased usage of local phone networks. Now, the Bells are rolling out a signaling network called Signaling System 7 that permits a whole new set gf services, such as Caller ID, call tracing, and selective call blocking. Bell Atlantic, the biggest booster of such services, says more than 390,000 customers have signed up for Caller ID alone. The company is also developing a technique for compressing full-motion video for transmission over standard phone lines. Says Chairman Smith of such advances: "We're not just doing it to shine up the old telephone plant. It's going to be a revenue producer."

Indeed, "increase traffic" could be the mantra of the new breed of Bell executives. Nynex Corp. is going so far as to carry business-television signals for Dow Jones & Co. over its fiber-optic network in New York City. The TV biz doesn't come naturally to a phone company, admits Donald J. Sacco, Nynex vice-president for human resources and planning. But, he asks: "Tell me what else you want me to do: Sit here and get smaller and smaller?"

UNLIKELY SCENARIO. Getting smaller is exactly what the inheritors of the old Bell System fear most. Ever since the reign of Theodore Vail, Bell executives have warned that competition could hurt the average customer by skimming off the most lucrative business traffic, stranding a worn-out old network with the least-profitable users. That unlikely scenario could still unfold - but only if regulators bungle their jobs and the Bells themselves miss opportunities open to them to turn their networks into heavily traveled information highways of the future.

The Bells still have a few years to change. Even Pacific Telesis' Sam Ginn, who's wrestling with whether his company should be cut in two, says: "This is not something that was forced in a time of crisis." But there is a sense of urgency. If they blow this opportunity, the Niagara Falls of competition that Ameritech's Weiss expects could sweep the Bells over in seven identical barrels.

      Rules and rulings that are helping and hurting the Baby Bells:
      On Sept. 17, the FCC allowed small competing networks to connect with the
      Bell networks and lease circuits from them.  This means the newcomers can 
      compete in a broader market.  In exchange, the Bells gained pricing flexibility
      Last year, a federal judge allowed the Bells to create information services 
      such as an electronic yellow pages.  But they are still banned by a consent 
      decree from manufacturing telecom gear and carrying long-distance calls
      The Bells got permission in July to deliver television channels to homes and to 
      own up to 5% of the stock in a programmer or cable-tv operator.  But they can't 
      own cable systems, even under the main cable-reregulation bills in Congress

By Peter Coy in New York and Robert D. Hof in San Francisco, with James E. Ellis in Chicago and bureau reports

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