AT&T Hits a $5 Billion Wall

A cash crunch weakens its hand in merger talks with BellSouth

Will Mike Armstrong ever get a break? Just as AT&T (T ) is embarking on a possible merger with offshoot BellSouth Corp., BusinessWeek has learned he now has to navigate a treacherous cash crunch.

Armstrong announced Oct. 3 that AT&T would cut capital spending at the core telecom unit next year by 20%, or about $1 billion. And one AT&T source says the $3.5 billion capital budget at its cable unit could be cut by up to $1 billion. Armstrong is also contemplating a debt offering of as much as $5 billion to $6 billion to bolster its reserves, according to sources. Those reserves had stood at $9.7 billion at the close of the second quarter. AT&T's current cash level won't be released until third-quarter financial results are announced later this month.

"LITTLE LEVERAGE." AT&T execs won't comment on their cash position. But the need to raise funds is a stark sign that AT&T's bind is far worse than many on Wall Street now realize. It will force AT&T to make even larger debt payments at a time when it can ill afford extra costs. Even more critical, added debt will give the telecom giant little negotiating room with BellSouth (BLS ). "AT&T has very little leverage. They are at the mercy of whomever wants to purchase them," says Scott Cleland, CEO of Precursor Group, a telecom research firm in Washington.

How did things go from bad to worse in seemingly no time at all? For starters, AT&T has been unable to raise urgently needed cash through sales of its minority stakes in cable outfits Time Warner Entertainment and Cablevision Systems Corp. AT&T had hoped that AOL Time Warner Inc. (AOL ) would pony up roughly $9 billion for the Time Warner stake alone, but the two sides have been bogged down in price negotiations. An additional $7 billion to $9 billion never materialized when AT&T scotched the AT&T Broadband public offering, following a bid for the cable unit by Comcast Corp. (CMCSA ) in August.

The economic slowdown has also taken a big toll. Even before the terrorist attacks last month, both its business and consumer units had been falling off sharply, insiders say. With prices falling, AT&T has been rapidly losing share in the consumer long-distance market. And industrywide revenue growth from the sale of high-speed data services is only 15%, about half what was expected.

So why does BellSouth want AT&T and all the problems that come with it? For Atlanta-based BellSouth, which delivers local phone service to nine Southern states, snaring AT&T would enable the Baby Bell to go beyond its current status as a regional player, and it would deliver global corporate customers.

So far, the talks have included several possible scenarios. AT&T may sell its cable business to Philadelphia-based Comcast. That would give Armstrong a free hand to cut a deal to combine the remaining consumer and business-services units with BellSouth's local-phone networks. Alternatively, BellSouth might even bid for all of AT&T, including its cable assets. The terms of any deal and who would run the new company are still open, though Armstrong is looking for a merger of equals. BellSouth declined to comment, but one inside source confirmed serious talks are underway.

Now, adding to all the other complications is the prospect of a big chunk of new debt. Moody's Investors Service already has AT&T on credit watch with a rating of A2, the lowest level in its top tier. Standard & Poor's also has AT&T under credit watch with a rating of A. Far more critical, any new evidence of financial problems at AT&T could reduce the price BellSouth CEO F. Duane Ackerman is willing to pay.

MISGIVINGS. Moreover, there's still dissent within BellSouth over whether or not AT&T is a suitable partner. One faction within management feels that "Sprint is much closer to BellSouth in terms of its fiscally conservative management style and is much better managed than AT&T," says one source.

Those doubts are well placed. All long-distance companies suffer from falling prices and slowing growth. And BellSouth would inherit AT&T's stake in bankrupt Internet company, Excite@Home, as well as its the troubled Concert venture with British Telecommunications PLC.

If a deal doesn't get done, the downside may be felt by the entire telecom sector. Consolidation could help bring about a healthier, leaner industry, one reason why regulators might approve a reunion of AT&T with a part of the original Bell system. "Approval is possible, although it would have Kevlar-strength conditions," says Precursor's Cleland. AT&T might have to divest all its assets in BellSouth's home markets in the Southeast, "down to every last paper clip." That just might be a price Mike Armstrong would willingly pay.

By Steve Rosenbush in New York, with Ron Grover in Los Angeles and Charles Haddad in Atlanta

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