John Malone's Sweet Split with AT&T

Thanks to a contract Ma Bell's Mike Armstrong inherited, he'll be paying millions to Malone's Liberty Media for years

By Ron Grover

The long-awaited breakup of AT&T seems to be moving smartly ahead. On May 30, the phone and cable giant announced it had received approval from the IRS to spin off its wireless unit with no negative tax consequences for shareholders. That should be accomplished by the end of the summer, the company says.

About that same time, AT&T is expected to also spin off Liberty Media Corp., the company headed by cable mogul John Malone. Liberty has stakes in such programming assets as Discovery Network, QVC shopping channel, and such media and communications companies as AOL Time Warner, News Corp., and Viacom.

Anyone who has followed the short and tortured relationship between AT&T and Liberty knows that the split can't come too soon for AT&T Chairman Michael Armstrong. He has seethed since AT&T's 1999 acquisition of Malone's Tele Communications Inc. The $36 billion deal, which included TCI's separately traded Liberty Media, not only saddled the phone giant with a huge cable-TV system that badly needed technology upgrades but also tethered Armstrong to Liberty, which he helped fund but didn't control.


  Malone, sitting on the AT&T board and taking the occasional potshot at Ma Bell's head guy, could pretty much run Liberty Media as he wanted -- with $5 billion in AT&T money to play with. And he could do it all with a smile, as AT&T's board looked on helplessly.

All of which is why Liberty's split from AT&T is pretty much expected to happen on schedule. But Malone has already left a going-away present for Armstrong, who is expected to run the huge cable service after AT&T splits into four units later this year. That present is a neat little contract that dates back to the Malone's TCI days. Signed on July 1, 1997, it required TCI's cable systems to carry the Liberty-owned movie channels Starz and Encore and its 13 other e-channels under its Starz Encore Group.

Encore, with such unambiguously named assets as the Action, Romance, and Western Channels, segmented its programming by genre and filled up as many channels as it could on the TCI cable systems. This deal is in place until 2022. And the money was considerable. TCI was required to pay a flat fee for each of its subscribers -- regardless of whether their systems even had enough channel capacity to take all of Liberty's channels.


  By 2003, that would have meant something north of $315 million in income from TCI cable subscribers alone, according to the last TCI financial statements I could find. And the payment amounts were scheduled to rise along with the rate of inflation. And what can Armstrong -- who inherited the deal -- do about it? Nada. Tough luck, Mike.

The agreement is classic John Malone. Struck just as TCI was making plans to put itself up for sale, it ensured success for Malone's group of pay channels, which were grouped under Encore Media Group. Encore, which eventually became part of Liberty Media, was having a tough time latching onto agreements with cable services, most of whom were already running HBO and Showtime for their customers and didn't much see a need for a third movie channel.

So, when AT&T bought TCI in 1999, it got stuck paying a monthly fee to Liberty for those 12 million or so TCI subscribers it inherited, even though a big chunk of them couldn't get all the movie channels because their cable systems got only 30 or 40 channels. That meant AT&T was forced to spend billions to upgrade the systems to accommodate as many as a 100 or more channels.

And here's the kicker: When AT&T acquired any other cable systems, it was stuck in the same deal. So when it went out in 2000 and bought 4 million new subscribers through its acquisition of MediaOne, it started writing bigger checks to Liberty for those same movie channels -- again, even if the folks couldn't get them. Cha-ching!! That's the sound of money hitting Malone's bottom line.


  The impact of this deal on AT&T is fairly substantial. Rich Bilotti, the highly regarded media analyst for Morgan Stanley, figures it has sliced some 2.5% off AT&T cable's operating margins. For a cable company with $8.2 billion in revenues and cash flow of some $1.7 billion, that's not small change, around $40 million or $50 million.

But I don't think the issue is so much the money as the principal, especially when you have the kind of relationship that Malone and Armstrong seem to. Bilotti brought up the possibility of renegotiating the deal during a recent conference call that Liberty Media held. What he got in return was a nonanswer from Robert "Dob" Bennett, Liberty's president and chief operating officer. "We're all businessmen," said Bennett. "If [AT&T] has a proposal that's mutually beneficial, we'd be happy to discuss it."

That means forget it. And why should Liberty want to do anything about the deal? According to the company's most recent quarterly earnings report, its Encore unit is doing very very well under the current system. In the first quarter, its cash flow was $77 million on revenues of $209 million, both up by double-digit percentages. That gives the pay channels an operating margin of some 37%, roughly double what AT&T's cable systems reported last year. As for growth: All those new MediaOne subscribers added a year ago added up to a 20% jump in revenues.

No wonder the deal sticks in Armstrong's craw. And it's just one more reason why the AT&T chief will be thrilled to see Malone go -- even if a little parting present sticks around after the farewells.

Grover is Los Angeles bureau chief for BusinessWeek. Follow his weekly Power Lunch column, only on BW Online

Edited by Patricia O'Connell

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