Armstrong Is Screwed>
Business Week: October 18, 1999
Cover Story
AT&T: The Problems Keep on Coming
Can Armstrong manage his way around enormous pitfalls?
Alisa Daskarolis signed up for local telephone service from AT&T in mid-August, and she's not happy. ''Can you hear that?'' the 39-year-old math teacher asks as a loud hum interrupts a phone interview. She is using AT&T service that runs over a cable-TV network, new technology that is essential to the future of the company. But if this is the future, it has left Daskarolis wanting. She says she can't use her cordless phone in all the places she used to. ''I can't go into the garage. I can't sit outside on a sunny day,'' she says. And she can't get over how her first month's billing got messed up when AT&T charged her $93, and she owed $53. After she complained, the company fixed its mistake, but it left her irked. ''That's the kind of stuff that makes life frustrating,'' she says.
It's also the kind of stuff that AT&T can't afford right now. When C. Michael Armstrong arrived as CEO two years ago, he could do no wrong. He lifted the moribund giant out of years of stagnation and charged ahead with a strategy to move AT&T into fast-growth markets. But something has gone awry. The company's long-distance business is crumbling faster than expected, and Armstrong's bet that cable is the way out is hitting snags (chart). As if that weren't enough, the competition just got a whole lot scarier: On Oct. 5, MCI WorldCom Inc. announced a $129 billion deal to acquire Sprint Corp., creating a powerhouse that nearly matches AT&T in long distance--while being far mightier in Internet services. ''This merger allows us to compete head-on with AT&T,'' crows John Sidgmore, WorldCom's vice-chairman.
Indeed, the potent WorldCom-Sprint combo only brings AT&T's high-wire strategy into stark relief. Now WorldCom CEO Bernard J. Ebbers is packing a holster full of weapons to attack the industry leader--wireless, Net, long distance, international, and even local services. And Ebbers, a pragmatic former motel manager, will be using tried-and-true technology instead of the unproven cable-TV networks that the bold Armstrong is betting on. Armstrong has ponied up $110 billion to acquire two cable companies and will have to spend an additional $7 billion spiffing up the networks--mega-money that has Wall Street in a stew that AT&T will never see a payoff.
Making matters worse, just when Armstrong could use seasoned hands at his side, he's wrestling with turmoil in his top ranks. The latest development: On Oct. 6, Leo Hindery Jr., the respected cable-industry veteran who was overseeing AT&T's push into cable telephony and Internet services, stepped down. That's the sixth top exec to depart in the past 21 months. Even John D. Zeglis, a brainy lawyer who has taken on the critical operational role of president, considered another job recently.
DEFENSIVE. AT&T stock, which had been on a tear since Armstrong's arrival, is in a swoon. Shares have tumbled 27% from their high in January, to 46 5/8, slashing AT&T's market capitalization by about $55 billion, to $149 billion. Over the same period, the Standard & Poor's 500-stock index is up 6%, and WorldCom's stock has slipped a modest 9%.
Suddenly, the seemingly indomitable Armstrong is on the defensive. Some have begun to question whether he will pull off his radical plan for transforming AT&T. After arriving from defense contractor Hughes Electronics Corp., the tough-talking, Harley-riding CEO quickly laid out a road map for making his new company less reliant on the long-distance business. His goal: to broaden AT&T into a communications behemoth, offering everything from speedy Net connections and telecom consulting to wireless and local phone service--to anyone, anywhere, by any means. It is a transformation on the scale of General Electric Co.'s makeover--from an appliance maker into a powerhouse in businesses as diverse as finance, entertainment, and jet engines.
Armstrong's task is no less onerous (table). He has broken from the pack by entering the $100 billion local telephone market through phone service over cable-TV pipes. The only problem is that cable systems are notoriously unreliable. That means he must make the cable networks as rock-solid as phone systems that have been fine-tuned for more than a century. While cable telephony has worked in the labs, the challenge of broad usage has defeated some of the country's best engineers. The conundrum: Cable phones operate on a network that customers share with their neighbors--so interference from the guy down the block can wreak havoc on phone quality. ''I battled this for 10 years and threw in the towel,'' says Ralph Ungermann, who began working on cable telephony in the mid-1980s at Ungermann-Bass. ''I think there are real serious technical problems.''
''EXECUTION.'' Hogwash, says Armstrong. He characterizes concerns over AT&T's strategy as misplaced and overblown. Sure, a price war is battering his long-distance business, but he points out that the company is cutting costs so aggressively that it will continue to generate the cash that's essential to fund new businesses. And he is as committed as ever to cable. He believes that phone calls over fat pipes will become a formidable competitor to the existing phone networks as AT&T works out the kinks over the next year. ''You know how in real estate the mantra is: location, location, location,'' he says. ''Ours is: execution, execution, execution. We have the game plan and we have the technology. Now we have to make them work.''
But can he? It will take near-flawless management to avoid the enormous pitfalls on every side. The long-distance business looks like a disaster in the making. And a massive rollout of cable telephony will be so complicated that it could very well take longer--and cost far more--than expected.
Here's what makes the task so tough. With Armstrong spending $110 billion in stock on two cable companies, earnings in the next few years will be watered down--because they're sprinkled across more shares. To boost income enough to make the deals contribute to earnings by 2004, Armstrong will need 7.6 million cable telephony customers paying nearly $800 a year, or $66 a month, and 5.6 million Net access subscribers paying $340 a year, or $28 a month. Those are ambitious goals, considering the company's customers now number a mere 3,000 for cable telephony and fewer than 1 million for Net access. Given the technology, marketing, and management risks, many investors are skeptical that Armstrong can hit such high targets. ''I think he's screwed,'' says Sanford Rich, a managing director at GEM Management Capital, a money manager that invests in telecom stocks but does not hold AT&T.
If Armstrong can prove the skeptics wrong, though, the payoff will be enormous. He's banking that revenues from the cable operations will grow an average of 24% annually for the next five years, to $21.6 billion in 2004. That will more than make up for the slowdown in the long-distance business. Along with the vibrant wireless and consulting operations, cable would push AT&T's revenues up more than 10% per year, to nearly $100 billion in 2004.
Already, Armstrong is making progress. Thanks to innovative marketing and pricing plans, AT&T Wireless Services is soaring. One big reason AT&T still expects to hit Wall Street forecasts for this year is that the company figures wireless revenues will rise 40%, to $7.6 billion. AT&T Solutions, its consulting and outsourcing business, is expected to jump nearly 50%, to $1.6 billion. And the broadband Internet access service Excite@Home, in which AT&T holds a majority voting stake, boosted its number of customers 35%, to 620,000, between the first and second quarters.
Armstrong will need every bit of that to make up for troubles in the long-distance business, where AT&T still gets 72% of its revenues. Rivals MCI WorldCom and Sprint Corp. unveiled aggressive new price cuts this summer that forced AT&T to respond with its own 7 cents-a-minute offer. The result: Revenues in the consumer long-distance market will decline as much as 5% this year, concedes Armstrong. At the same time, he says, growth in business long distance will slow to 7% or less, compared with the 9% that analysts were expecting. All told, AT&T's long-distance revenues will be roughly flat, at about $46 billion, vs. the $48 billion analysts originally predicted.
MAVERICK. And with Baby Bells such as Bell Atlantic Corp. preparing to enter the market, it's bound to get worse. That's especially true in the consumer long-distance market, where AT&T's revenues are expected to drop 8%, to $19.8 billion, in 2000, according to analyst Tod A. Jacobs of Sanford C. Bernstein & Co. ''Wall Street is right to be worried,'' says Mark Bruneau, president of the business-strategy group at Renaissance Worldwide.
It doesn't help that AT&T is struggling with cultural clashes. Already, the mixture of the tradition-bound phone company, two maverick cable players, and a relatively new chief executive is showing signs of strain. There were tensions between Armstrong and Hindery before Hindery's abrupt departure, insiders say. Hindery lost much of the independence he had at TCI, while Armstrong felt Hindery wasn't committed enough to meeting his financial goals. That could foreshadow even more conflicts between the button-down CEO and the rough-and-tumble cable execs.
And Armstrong may soon lose another key manager. Zeglis, who was a serious candidate for the CEO post at AT&T when Armstrong was named, has suffered recent setbacks. When Hindery argued that he should report directly to Armstrong instead of to Zeglis, Armstrong agreed. Now Zeglis has no responsibility for the cable operations. And Zeglis didn't play much of a role in the MediaOne acquisition. He toyed with taking the top post at Compaq Computer Corp. before pulling himself out of the running earlier this year, and headhunters say he's willing to consider other jobs. Zeglis says only, ''I'm doing thrilling things. No, I'm not out looking.''
Executive turnover has prompted a number of questions about Armstrong's leadership style. While the company used to have a collegial culture, Armstrong is demanding and gruff. ''Nobody ever got dressed down before, but Mike has done that several times,'' says one former executive. He's particularly tough on execs who don't deliver on revenues and expense targets. ''If you're not on your numbers, there's a lot of fear and trepidation when you go to see him,'' says Tom Byrnes, a former AT&T manager.
At times, that has bruised egos and damaged morale. Some execs feel he has been dismissive of longtime AT&T managers and what they have accomplished in the past. ''That has convinced some people to think about leaving,'' says a top manager who recently departed. Indeed, a survey of AT&T employees conducted in January and February showed that job satisfaction decreased the closer execs were to the top--the opposite of what personnel experts tend to find.
There are those, however, who say Armstrong's tactics are exactly what AT&T needs. ''The culture is definitely changing, and some people who are lifers may not like that. But I think it's for the good,'' says Joel Gross, a former AT&T exec who is now chief financial officer of telecom startup Broadview Networks. Armstrong sets quantitative goals throughout the organization. Salespeople in the business-services unit must now meet revenue targets that range from $5,000 to $20,000 per month. ''Yes, he's relentless,'' says Zeglis. ''I think in our situation I would accept nothing less than a leader who is as demanding as Mike Armstrong. We have a lot to do.''
For starters, AT&T is facing a regulatory battle over its proposed $62 billion acquisition of cable player MediaOne. Along with the acquisition of TCI that closed in March, the MediaOne deal could put AT&T over the Federal Communications Commission's limits on cable ownership, depending on how the FCC votes to revise its rules for cable ownership on Oct. 8. AT&T argues that it shouldn't have to dispose of any properties, but regulatory analysts say there's a chance AT&T may have to sell the 25% of Time Warner Entertainment that MediaOne owns or other assets. ''It's not a matter of if they're going to sell, it's a matter of how much they're going to sell,'' says analyst Scott C. Cleland of Legg Mason's Precursor Group.
CLOUDED. Just as crucial is how regulators affect AT&T's push into the business of selling broadband Net access. Through Excite@Home, the company is offering Net connections that are 20 times faster than today's traditional cable modems. But AT&T could get tripped up: Several cities say that because cable is a monopoly service, the company should have to let competitors such as America Online Inc. sell Internet access on its network. Portland (Ore.) officials plan to force AT&T to share its cable network, and earlier this year the city won a U.S. District Court ruling against AT&T upholding the decision.
Uncertainty will cloud the issue for several more months. The Ninth Circuit Appellate Court, which will decide an appeal of the Portland decision early next year. AT&T is confident that it will prevail, and most Wall Street analysts agree. But regulatory experts are less certain.
That's only the start of the problems with Excite@Home. There are simmering tensions between Excite and AT&T. Excite CEO Thomas Jermoluk wants to dish up content such as news stories and chat services along with Net access. AT&T, on the other hand, doesn't want Excite in the content business so it can market Net access with any content a customer wants, be it from AOL or Yahoo! Inc. ''It would be a less valuable position for us to saddle up to a particular content provider,'' says John C. Petrillo, the company's strategy chief.
The most critical challenge for AT&T, though, is rolling out cable telephony. In the Fremont trials, the experiences of customers such as Daskarolis suggest there's work ahead. Even glitches with the Excite@Home service are beginning to reflect on AT&T's phone service. Fremont resident Bruce J. Brown says the reliability of Net access is so spotty that he turned down an offer to be part of the phone-over-cable trial and receive $150 a month. ''God, no, I'd never touch that,'' he says. ''As far as I can tell, their infrastructure can't support reliable Internet service. Why would it provide reliable phone service?''
AT&T says cable technology is going to work just fine. It's operating in five test markets and is being sold commercially in Fremont and Chicago. The company plans to limit commercial and test users to 3,000 until the end of the year so that it can carefully work out any problems. ''We're learning a lot about this business,'' says Curt Hockemeier, who is overseeing the effort. ''In a word, the trials are going great.''
So where does all this leave AT&T? The company's future may well be determined in the next year. If WorldCom gets approval to buy Sprint, the company will face a stronger competitor. How much of MediaOne it gets to acquire will affect the breadth of its reach in the U.S. And if AT&T can't get cable telephony to work on a massive scale at a reasonable cost, it will be in serious trouble. In the meantime, Armstrong's plans for a grand transformation hangs in the balance.
By Peter Elstrom in New York
Copyright 1999 The McGraw-Hill Companies, Inc. All rights reserved. Any use is subject to (1) terms and conditions of this service and (2) rules stated under ''Read This First'' in the ''About Business Week'' area.
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