A Spin-Off with a Hangover

AT&T is losing Liberty Media--but not the sting of its CEO

It is one of those red-letter days that AT&T (T ) Chairman C. Michael Armstrong no doubt has circled on his calendar. On Aug. 10, AT&T will spin off Liberty Media Corp. (LMG.A ), the television programming unit headed by recently departed AT&T board member John C. Malone. Malone has been a thorn in Armstrong's side ever since AT&T bought Malone's Tele-Communications Inc. cable company for $44 billion in 1998. But if Armstrong thinks Malone is going quietly, he had better think again: Even as Armstrong struggles to fend off cable competitor Comcast Corp.'s (CMCSK ) unsolicited $40 billion bid for AT&T's cable assets, Malone is plotting new battles.

This is not merely about money. It's also personal. Malone and Armstrong never hit it off, say insiders. Matters only got worse when Malone, furious that his stake in AT&T lost $1 billion on Armstrong's watch, angered Armstrong in turn by criticizing AT&T's strategy in the press. And he's quietly been selling off much of his AT&T holdings, having sold nearly 20% of his $502 million stake this summer alone.

Now the Armstrong-Malone tensions are flaring up anew. The very day Malone left the AT&T board last month, he gave Armstrong the ugliest of parting gifts: a lawsuit filed by Liberty's Starz Encore premium cable service seeking $44 million it claims it is still owed. Elsewhere in his cable empire, moreover, Armstrong is likely to see Malone's fingerprints. Under another Malone deal, for example, AT&T is embroiled in protracted talks about how much Liberty Media will pay to use up to 15 AT&T cable channels. Then there is the issue of Rupert Murdoch. Liberty has put up $1 billion to help Murdoch's News Corp. (NWS ) bid for General Motors' DirecTV, making Malone an ally in snatching cable customers from AT&T. "Welcome to the real world, AT&T," says Christopher Dixon, a UBS Warburg analyst who follows Liberty Media.

Much of this is the nasty residue of a deal that Armstrong negotiated in haste, buying TCI in a two-week whirlwind in 1998. Armstrong inherited a deal that requires AT&T to pay a flat monthly fee to carry the Starz Encore programming and also requires it to pick up most of any increase in programming costs. Most other programmers charge a monthly fee per subscriber, with the cable company negotiating price hikes in later years. Last year, AT&T paid Starz Encore a $264 million flat fee. But this year, it refused to pay an additional $44 million bill for its share of cost increases. Liberty wants AT&T to pay up. AT&T refuses comment.

Now AT&T is fighting back. In Securities and Exchange Commission filings, the company has called the 25-year contract to carry movie channels from Starz Encore "unenforceable." And it is expected to argue in a response to the suit that the inherited contract was improper.

MINGY MARGINS. Improper or not, the terms of the deal have clearly created a problem for AT&T's bottom line. AT&T's deal with Liberty has already slashed an estimated 2% off AT&T's slim cable-profit margins, according to industry insiders close to the Comcast negotiations. That may be one reason AT&T has been negotiating so strenuously with Liberty Digital, a Malone-controlled company that has the rights to use 12 to 15 channels on AT&T cable systems for its own interactive travel, shopping, and other programming. Shopping channels like QVC pay 5% of their sales to AT&T. AT&T is said to want more than that from Liberty Digital.

All this distraction is hardly what a beleaguered Armstrong needs now. In the wake of the Comcast bid, he has been working to line up potential merger candidates that may include Walt Disney Co. (DIS ) At the same time, News Corp.'s Malone-backed deal to buy DirecTV (GMH ) is also moving forward, despite an eleventh-hour bid by rival EchoStar Communications Corp. (DISH ) Malone has openly called Rupert Murdoch "my domestic cable play," which would put him on a collision course with AT&T.

Armstrong would like nothing better than to smooth over the spats with Malone. A few weeks back, he called his former board member at Malone's Maine vacation home, offering to have a meeting to settle the Starz Encore matter out of court. Malone agreed to talk. That's good for starters. But backing down is a very different matter.

By Steve Rosenbush in New York and Ronald Grover in Los Angeles

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