The vultures are circling. Venerable telecom titan AT&T is on the ropes, splintering into four smaller companies under the weight of the massive debts and plummeting stock values that are the legacy of CEO C. Michael Armstrong. But make no mistake: AT&T is still the biggest, most recognizable company in telecommunications. The onus is now on President Dave Dorman and his executive team to engineer a last-second comeback.

Over the past 20 years, AT&T has endured one antitrust suit defeat, gone through four chief executives, spun off more than a dozen independent companies and dabbled in everything from computer manufacturing to cable TV. Now the onetime phone monopoly slowly is breaking into four smaller companies, including a pending tracking stock for its consumer long-distance division — a move one competitor likened to “watching Coca-Cola get out of the soda business.”

It's even become conventional wisdom that if AT&T keeps shrinking, it may soon disappear entirely, swallowed by a stronger telecom competitor. But spinoff strategies, which are necessary for the financial health of the company, are only one part of the story.

Inside AT&T, the company has begun developing a strategy for turning around the business. The new message is simply that given its size, brand and customer list, no other telecom company can compete. “I've been preaching only one gospel, and that's the gospel of scale,” said AT&T President Dave Dorman. “I don't fully understand why people write us off. We're a $40 billion company, and I've heard us referred to as a stump or a rump. That's an awful big rump. We're going to use our size and scale and leverage it in ways no one else can match.”

But after the company's cable unit was gobbled up by Comcast last year, the question is whether Dorman and company can turn AT&T around before the rest of the business becomes a takeover target, too.

The last time everything at AT&T was going according to plan was three years ago, when in February 1999 the company announced a deal to offer phone service on Time Warner's cable system. AT&T CEO C. Michael Armstrong and Time Warner head Gerald Levin smiled and posed for the cameras as they cemented the joint venture deal, which was supposed to be the first of many such partnerships. Armstrong played it up as the beginning of a new era for AT&T, which expected to use its own cable system and dozens of joint venture partnerships to build a national cable network, smashing the Bell companies' stranglehold on local phone markets.

The plan fell apart even before it was launched: The Time Warner deal blew up when Armstrong was caught secretly negotiating with AOL. There were few victories for the company after that — almost exactly one year later, AT&T bought cable titan MediaOne and passed Time Warner to become the largest U.S. cable company. But that deal only bloated the company's debt and could not give AT&T the national footprint it craved. For the most part, AT&T's cable strategy was nothing but a drain on company resources, leaving it $56 billion in debt and sending its stock lower than it had been when Armstrong took over in late 1997.

Armstrong was an ambitious leader, but he never proved to be an effective leader at AT&T. Shortly after the 1999 acquisition of TCI, he wrote in a memo that he wanted to approve every price change as well as every new hire AT&T made — this in a company with thousands of price changes a week and more than 300,000 employees at a given time. (Armstrong was unavailable to comment.)

“[Armstrong's] got the looks and the charm to make a great chairman,” said one former AT&T executive. “But he doesn't have what it takes to be a manager.”

The idea of AT&T buying cable companies made sense when it began with the acquisition of TCI. At the time, the network costs of a phone call were only about 15% of the cost of the call itself, and access charges — the fees long-distance carriers pay the regional phone company — accounted for 35% of the costs. With a cable network delivering phone services on top of digital TV and other enhanced services, AT&T could increase its cash flow and at the same time avoid paying those onerous access charges. But AT&T was blindsided by the massive cost of upgrading TCI's outdated cable networks, and the cable unit's margins soon ranked among the worst in the industry.

To undo the mess that had been made, Armstrong decided to break AT&T's units off into tracking stocks, making billions from the IPO while unlocking the true value of the units in the public markets. But even that strategy is not going according to plan: Comcast came in and bought out the cable unit for $72 billion before it could be spun off. AT&T's debt is now down to a manageable $20 billion, but it has lost all control over its erstwhile cable holdings. And its image as a company in control of its destiny is seriously damaged, as Armstrong has been largely unsuccessful in convincing the world there is a method to his acquisition and de-acquisition madness.

But the failure of the cable gambit does not mean AT&T is dead in the water. While Armstrong is trying to solve the problems created by his adventures as a cable operator, Dorman and AT&T Consumer President and CEO Betsy Bernard have been working quietly behind the scenes to engineer a turnaround.

It's not an impossible task. This is, after all, a company with market capitalization of about $64 billion. The business unit alone, with 4.2 million customers, pulled in $28.5 billion last year. And even the much-maligned long-distance unit still claimed more than 50 million customers, $19 billion in revenues and margins of 37.4% in 2001.

With more than $65 billion in total revenue last year, AT&T is still larger than any other U.S. telecom firm, ranking ninth on the Fortune 500 list. Yes, the company is a shell of its former self. But it is still a mighty big shell.

Now the fight of AT&T's life is to outrun its own progeny. If an acquisition is in the cards, the former Bell companies are among the few with the wherewithal to buy the company. But it is hard to imagine regulators easily accepting the idea of a Bell company and AT&T merging to recreate a sort of mini-Bell system, especially after the government went to the trouble of breaking apart the old system in 1984.

And with regulators finally taking a hard look at the Bells' attempts to enter the long-distance markets, it may be years before one of them enjoys the freedom to make a run at buying AT&T. In the meantime, AT&T has this one window of opportunity to sort out its business.

AT&T might be ready to spin off the consumer long-distance business as a tracking stock, but that doesn't mean management is giving up on the business. Most depressing to Dorman is analysts' suggestions that long distance is worth a meager $1 a share as a stand-alone company. “The question I am always asking is why AOL gets the play they do with 33 million subscribers at $22.95 a month — or whatever it is now — and here we are with 50 million customers who are paying well north of $20 a month,” asks Dorman. “Why is it this franchise is so unpopular with Wall Street?”

But anyone who has watched AT&T's steady decline in consumer long distance over the past few years knows the slide is probably irreversible. The company, which could claim more than 90 million long-distance customers just a few years ago, now boasts less than 60 million, a number that continues to fall. And as the local phone companies gain approval to offer long-distance service on a state-by-state basis, they inevitably win huge portions of the business. “Can we win in terms of body count? No,” said Dorman. “But can we get the high-value customers? I think the answer is decidedly yes.”

High-value customers could be the stabilizing force the long-distance business needs, Dorman said. In six states where Bell companies have long-distance approval, AT&T said that they tend to win customers whose call volume is 20% to 25% higher than the average consumer. The maxim in this business is that 20% of long-distance subscribers are responsible for 70% of the revenues. AT&T intends to keep those 20% while letting the Bells poach the less-productive consumers.

And while Bell companies poach AT&T long-distance customers, AT&T believes it can steal their local customers. While Armstrong famously blew $100 billion on cable to get into local phone markets, in March 2001 AT&T managed to buy the assets of bankrupt DSL provider NorthPoint Communications for a mere $135 million. In the process, it gained 2000 co-location facilities and CLEC status nationwide. Dorman claims that for $100 million or more, the company can upgrade those facilities to offer local phone and data services.

Unlike DSL upstarts like NorthPoint, AT&T is not going to use these facilities just to sell a fat pipe, but it will use that fat pipe to sell bundled retail services. If the strategy sounds oddly familiar, that's because it is a variation on what the company tried to do with its cable plant — only without the bundled cable TV services. That plan complements the local phone network AT&T already had in place, thanks largely to the $11.3 billion acquisition of CLEC Teleport Communications Group in 1998. “People don't realize the work we've been doing in local markets for years now,” said Maureen Rooney, AT&T's vice president of local connectivity services. “We've been in this business for five years now, and much of the ground work is done. We're just beginning to enjoy the fruits of our labor.”

AT&T is confident that winning customers from the Bells is not too hard once an alternative is in place. Dorman, himself a former head of Pacific Bell, knows firsthand how disliked the local phone monopolies can be, and he is counting on capturing disgruntled Bell customers and the abandoned customers of bankrupt CLECs. “At Pac Bell, I used to be horrified by the numbers,” he said. “Something like 25% to 30% of our customers said they would go somewhere else if they could.”

AT&T also is trying to tell the world that the Bells aren't in as great a position as people think. The regional phone companies used to be able to impress Wall Street with steady growth in access line deployment, but that metric has now become difficult to deliver. There is simply not as much growth to be had in local markets. The only way for the Bell companies to grow is in the enterprise, but that is where AT&T is strongest. And as the Bells move out of region into other local phone markets, most of their natural advantages disappear.

AT&T has quietly put together a portfolio of assets much broader than most in the industry. Not only does the company have the NorthPoint facilities to enhance its local network services, but AT&T also has minimal bets on some alternative and emerging access network technologies, including Ethernet and 38 GHz wireless licenses (inherited from TCG) — all aimed at winning more of the business market with alternative access technologies and services.

SIZING UP THE COMPETITION

Market capitalization (in billions of dollars) AT&T (T) - $64 Verizon Communications (VZ) - $135 SBC Communications (SBC) - $123 BellSouth Communications (BLS) - $73 Qwest Communications (Q) - $21 WorldCom (WCOM) - $38 Sprint (FON) - $18 Source: Yahoo! Finance

Last month AT&T introduced a new suite of virtual private network (VPN) offerings, advanced hosting services and new high-availability and security features for its global network. The VPN services offer, among other things, an upgrade path from older services such as frame relay to newer, IP-based networks. On the hosting front, AT&T is touting a platform called Integrated Global Enterprise Management System, a $200 million project developed by AT&T Labs. It is designed to measure availability, performance and usage on the network and manage accordingly to guarantee better service for individual corporate customers. This year AT&T has invested $300 million in its global network, adding 80 nodes, primarily in Europe.

But part of AT&T's problem is that the sale of the cable unit and the proposed spinoff of its consumer long-distance business are so distracting that the company gets little attention for the mundane and practical new services it does have. “AT&T has been sort of quietly expanding their portfolio, adding new services and applications,” said Dan McBride, securities analyst for H&R Block. “It's not clear yet if they're gaining traction, but they're moving in the right direction.”

Possibly the most pivotal strengths are AT&T's frame relay and ATM businesses, which are still profitable. The challenge now is to take that success and translate it to the IP services that are slowly supplanting frame and ATM. “I like to point out that our frame business alone is bigger than many of our competitors,” said Dorman. “The challenge is to get the same scale we have on frame and achieve the same or better on IP. I don't know who, besides AT&T and WorldCom, has the scale necessary to pull off that kind of transition.”

But with AT&T still reeling from the cable blowout, management needs must be brave enough right now to milk its older, cash flow-positive businesses and deploy that money to transform its data and voice services. The company recently announced that its data revenues have surpassed voice revenues, which indicates it is possible for data services to prop up and even supplant the dying long-distance business.

Of course, there is only so much time for AT&T to prove to the world that it can be a growth company again. “AT&T's margins are falling, and the company is being attacked on all sides by the ILECs,” said Lynda Starr, analyst for Probe Research. “Unless there's some decisive action soon, they'll lose their remaining advantages — the best brand name in the industry and their huge customer base.”

The plan now is to go on without any of the crazy schemes, like using cable companies to mount an end run around the Bell companies. AT&T now simply will use its remaining assets — namely, its massive size, networks, revenues and customer list — to grow profits. It's doing what the company should have been doing all along had it not been distracted by Armstrong's cable exploits. The hope is that it is not too late.

“We've had the pleasure of existing through the advent of the cell phone. We've had the pleasure of existing through the advent of widespread competition and massive price declines,” Dorman said. “The only thing that keeps us from being more successful is ourselves.”

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Jason Krause is a freelance writer based in Chicago. He formerly was a staff writer for The Industry Standard.

Wall Street's bloody hands

For the last five years, no company has been through as many tortuous changes as AT&T. Having already sold its cable business, the former phone monopoly is now finishing the process of splitting into three smaller companies — wireless, business services and long distance. But the reasons behind AT&T's wild financial maneuverings have little to do with how well the businesses have performed — and more to do with Wall Street's unrealistic expectations for the company.

In the early '90s, Wall Street wanted to see stodgy old AT&T perform as well as the hype-fueled, fast-growing telecom start-ups that had become the darlings of the Nasdaq. But in transforming AT&T into a growth-focused enterprise, management also may have dragged the profitable phone company to ruin with acquisitions that only mired it deeper into debt.

The interesting thing to note is that Wall Street was instrumental in prodding AT&T to take on its current debt load. Later, the same Wall Street types decided it was all a mistake, and now that the company is trying to undo the damage, investment banks are making a killing — AT&T's bankers' fees alone are probably propping up several Wall Street banks.

“There's no question AT&T has been in a tough position because of its debt load,” said one Wall Street analyst who asked not to be named. In fact, it's almost impossible to get any Wall Street analysts to talk on the record about AT&T these days. That's because analysts aren't supposed to comment on companies they are advising on business transactions. But the silence is somewhat ironic because these same analysts were more than happy to discuss AT&T when they needed to goad the company to make more acquisitions.

“Mike Armstrong probably spent too much time with his bankers and not enough time with his customers,” said Hilary Mine, vice president for industry analyst firm Probe Research. Mine believes Wall Street encouraged AT&T to become an integrated communications company but that analysts never determined how to assess shareholder value from the cost savings associated with acquiring and integrating multiple telecommunications companies.

Because AT&T failed to impress investors with its integrated strategy, it figures now the only way to impress them is to break those assets apart. “You can safely say that Wall Street never figured out how to assess the value of AT&T as an integrated company,” said Dan McBride, securities analyst for H&R Block, which caters to private investors. “The company probably would've been better served not breaking up.”

The figure below breaks out the valuations of each of AT&T's operating divisions as Credit Suisse analysts see it. Because Wall Street clearly values the company more for its pieces than for the whole, the company's current breakup strategy begins to make sense. Of course, it only makes sense in purely financial terms. What may be great for shareholders may be AT&T's undoing now as it is broken into smaller, weaker companies. When AT&T catered to the investment community by making bold acquisitions — and then bowed to pressure just a few years later to sell off those same assets — it set off a chain of events that has left AT&T in possibly the weakest position in its 100-year history.
— Jason Krause

 

AT&T ON THE BLOCK
Division	Valuation methodology	2001 EBITDA	Value per share
Consumer services	5x '01 EBITDA	$7.5 billion	$10
Business services	9x '01 EBITDA	$10.9 billion	$25
Cellular	16x '01 EBITDA	$2.6 billion	$9
Cable/video	14.5x '01 EBITDA	$3.3 billion	$12
Source: Credit Suisse