Ma Bell has gone deep into debt to buy a place
in the digital future. How risky is that?
by Jeff Schlegel
Shareholders didn't exactly jump for joy when AT&T
announced it was buying Tele-Communications Inc., the second largest
domestic cable operator. With a proposed price tag of more than $50 billion,
the acquisition seemed an expensive, scatterbrained foray into the unknown.
Even though AT&T CEO C. Michael Armstrong and a small army of AT&T
and TCI executives worked the financial news circuit, doing their best to
preach the virtues behind the marriage, shares of the phone company skidded
almost 10% on the day the deal was announced, then dropped another 25%
during the following two months, touching a low of $32.25 in early
September 1998.
As investors learned more about the deal, though, they began to like the ring
of Ma Cable. And last May, when AT&T outbid Comcast, the No. 3 cable
operator, for No. 4 player MediaOne Group, Wall Street was on board. At
more than $60 billion, the purchase price is even more expensive than TCI,
but AT&T shares jumped 17%, to $60.43, three days after its bid was
accepted. Why the mood swing?
Investors had come to recognize that cable was AT&T's best shot at carving
a niche for itself in the digital world. Because cable's fat broadband "pipes"
have a lot more bandwidth than traditional narrowband copper phone lines,
AT&T will be able to offer customers a full suite of services--including local
and long-distance telephone, high-speed Internet access, and such video
capabilities as broadcast television and teleconferencing--through cable wires
that feed into set-top boxes. And its stake in Internet service provider At
Home, which came with TCI, brought AT&T more than 300,000
cable-Internet subscribers. Web portal Excite (which At Home bought in
January) gives AT&T the content it needs to compete against Yahoo! and
America Online. No other communications company--not MCI WorldCom,
not AOL--can match that breadth and speed of services. AT&T will be a
one-stop shop, with the ability to entice--and retain--customers.
Coming at a time when AT&T continues to lose market share in its core
long-distance telephone business--Ma Bell's slice of that market has shrunk
from 91% in 1984 to 49% last year, and long distance is now the slowest
growing of its businesses--the attempt to break into high-margin, broadband
digital services seems like a stroke of genius. Industry-wide, revenues from
such traditional offerings as local and long-distance services are expected to
grow at an annual compounded rate of just 4% through 2003, according to
Robert Rosenberg, president of Insight Research in Parsippany, N.J.
Broadband services, including Internet access, should expand a healthy 15%.
"The AT&T brand name is very strong. When it has everything in place and
can offer bundled services it will be able to increase revenue and decrease
customer service costs," says Mel Marten, an Edward Jones analyst.
Even better, ownership of cable enables AT&T to save the fees it pays Baby
Bells for access to the so-called last mile connection into customers'
homes--in the first quarter, access fees were AT&T's single largest expense,
eating into more than a fourth of its revenue. "The perception was that AT&T
was facing the wrong way in the saddle," says William Tice, managing
director of the information technology and telecommunications consulting
practice at Abt Associates in Cambridge, Mass. "At least Armstrong has it
facing the right way as it rides into battle."
But investors should understand that the most widely held stock in America is
no longer the steady, rock-solid investment that widows and orphans could
count on for financial security. Cable systems need to be upgraded, and there
is no guarantee consumers will come in droves once that expensive task is
completed, especially if competing technologies create viable alternatives.
What's more, after assuming TCI's liabilities and issuing its own bonds,
AT&T has amassed a mountain of debt. Finally, AT&T must jump high
regulatory hurdles before it even can think of realizing its vision of becoming
the digital world's leading player. To be sure, the strategy provides enormous
opportunities for growth. But is AT&T really cable ready?
Copper lines were laid long ago to handle telephone calls, but they can't
accommodate such bandwidth-hungry functions as streaming video and
teleconferencing. There are two ways (besides laying broadband cable)
around that. A technology called digital subscriber line can add capacity
(bandwidth) and speed to copper lines, or a fixed wireless network can pick
up signals from the air through receivers outside homes and offices. Some
local carriers and Internet service providers are betting on DSL, while AT&T
has spent a lot on a fixed wireless network, dubbed Project Angel, for areas
where it won't have a cable presence. But it's important to remember that
neither DSL nor fixed wireless can handle video, and that cable's speed
blows both of those alternatives away.
That's why AT&T will have an edge if the MediaOne deal closes and makes
AT&T the nation's largest cable company, with direct access to 25 million
American homes. In addition, through various affiliations and partnerships
with other cable operators, to which AT&T will pay access fees, it has the
potential to reach 60 million homes, or 60% of American households.
But cable access is only part of the equation. In order to deliver all the
services it plans, AT&T's lines must support two-way communication. It's
one thing to broadcast MTV into people's homes; it's quite another to
facilitate interaction on the World Wide Web, which requires the ability to
send and receive information. TCI, now known as AT&T Broadband &
Internet Services, plans to have 50% of its cable infrastructure upgraded for
high-speed digital broadband capacity by year's end and as much as 90% by
the end of 2000, at a total cost of $2 billion. AT&T hasn't set a price tag or
time frame for upgrading MediaOne.
Added up, the numbers look scary. AT&T has committed more than $100
billion to buy TCI and MediaOne. Although it used its own shares to pay
part of the TCI bill, its long-term debt at the end of the first quarter rose to
$27 billion, up from $6.7 billion at the end of 1998. After factoring in the
MediaOne deal, AT&T could be indebted as much as $54 billion.
"One of the questions investors need to ask is how much time it'll take before
AT&T recoups its capital outlays and the price paid for its acquisitions," says
Crowell, Weedon & Co. analyst Douglas A. Christopher. Remember, too,
that the acquisitions will dilute near-term earnings. PaineWebber analyst Eric
Strumingher reduced his 1999 earnings estimate by $1 a share, to $2.23, to
account for dilution from TCI. For 2000, he chopped his original estimate for
AT&T by $0.40, to $2.05.
But financing may be just the start of AT&T's problems. Before it can even
get moving, Ma Cable needs local regulatory agencies to approve the
transfer of TCI's licenses. In early June a federal court ruled that local
authorities in Portland, Ore., and the surrounding county have the right to
require AT&T to ensure all Internet service providers, including AOL, have
open access to its emerging cable empire. (ISPs would pay access fees to
tap into AT&T's lines, but the great expense AT&T is undertaking makes
sense only if it gets to provide the service.) The fear now is that other
localities will feel emboldened by the Portland ruling, inviting intense scrutiny
from the Federal Communications Commission when it comes time to
approve the MediaOne acquisition. All those question marks could act as a
drag on AT&T shares, which already are 10% off their highs.
None of these problems is insurmountable. Cable broadband isn't based on
some kind of futuristic, pie-in-the-sky technology. In England, Cable &
Wireless already delivers telephone service over cable lines. In the United
States, Cox Communications has rolled out a small-scale cable broadband
system that delivers voice, data, and video to about 10,000 customers. And
in May, AT&T began testing cable phone service to 500 homes in Fremont,
Calif. Ten more pilot programs are on tap this year in preparation for a
wide-scale implementation in 2000, which should also include a range of data
services.
Then, too, AT&T isn't hurting for cash. It will receive a $5 billion investment
from Microsoft in return for a pledge to use the Windows CE operating
system in its set-top boxes. It plans to sell some of MediaOne's cable
properties to Comcast for $3 billion, with the potential for another $5.7
billion sale to Comcast down the road. And it hopes to generate $18 billion
more from the sale of such non-core assets as MediaOne's stakes in
international cable and wireless operations.
What's more, many of AT&T's businesses are doing well. Its wireless
operation, which is expected to account for more than 10% of revenue this
year, grew 34% in the first quarter. Revenue leaped 51% in its Solutions
group, which plans, installs, and manages computer networks. In fact, all but
two of its businesses--consumer and business long distance--grew revenue
by at least 7% during the quarter. All that makes AT&T a cash machine that
in 1998 cranked out nearly $20 billion in earnings before interest, taxes,
depreciation, and amortization. Warburg Dillon Read analyst Linda Meltzer
projects cash flow will grow to $21.9 billion this year, $24.6 billion in 2000,
and to $27.6 billion in 2001. That should be sufficient to cover capital
expenditures, with enough left over to reduce debt.
Finally, most observers think the Portland judgment is a nonissue. Says
PaineWebber's Strumingher: "We strongly doubt the FCC would leave
regulation of such an important public policy issue to local regulators."
Although Strumingher thinks the issue will cast a pall over shares in the near
term, he doesn't expect it to derail AT&T's cable strategy.
Still, AT&T can't afford missteps. "I'm highly skeptical they'll be able to pull it
off profitably," says Scott Cleland, managing director at Legg Mason
Precursor Group in Washington, D.C. "No one has done it before on such a
large scale, and historically such things cost a lot more than originally
expected."
Investors looking for positive omens should note that Armstrong has done a
good job integrating other acquisitions. In the first quarter, AT&T's purchase
of Teleport helped expand its presence in the profitable local business phone
sector by 90%, and AT&T completed its acquisition of IBM's Global
Network, a provider of corporate data services, one month ahead of
schedule. AT&T also made good on cost-cutting initiatives, trimming selling,
administrative, and general costs from 28% of revenue in 1997 to 22.4% in
the first quarter.
"Armstrong has transformed AT&T from a defensive player in the industry to
an aggressive competitor. He's done it by taking some risks, but that's a lot
better than maintaining the status quo," says Edward Jones' Marten. "You
can look out a few years and say earnings should accelerate, and investors
need to buy the stock now before that gets reflected in the stock price." That
is, if you can handle the risk.
MA CABLE'S BIG GAMBLE
AT&T will never be the same. In 1998, 73% of its revenue came from
providing long-distance telephone service. By 2004, the company projects,
less than a third will--the rest will flow from an array of digital services.
There's a huge payoff possible, but AT&T has taken on a mountain of debt.
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