AT&T's margin of error

Despite promises of a rebound, AT&T's cable unit posted startlingly weak cash flow, with already low profit margins sinking to the lowest point that industry executives have seen in a cable operator in about two decades.

For the first quarter ended March 31, AT&T Broadband posted cash-flow margin of just 16%. That's a five-percentage-point drop from what the company says was a 23% margin during the same period last year. When AT&T acquired Tele-Communications Inc. two years ago, the operation's margin was about 43%. That was within the 40%-50% range most other operators are still posting.

Industry and Wall Street executives acknowledge that launching advanced cable services will depress an operator's margins. But none expected AT&T executives to spend so heavily that they would take cable margins below 20%.

"It's shocking," said one Wall Street analyst. "How can they go public when they have numbers like this?" That's a reference to the planned separation of AT&T Broadband from the rest of the company, the first stage of which is scheduled for this summer.

"I don't where I'd spend that kind of money if I wanted to," said a senior executive with another major MSO.

AT&T Broadband Chairman Dan Somers said the division's cash flow will turn around later in the year. Last year, his goal was to heavily push sales of cable telephone services, high-speed Internet access and digital cable. For 2001, "our top priority is [cash-flow] growth and margin improvement with sustained revenue growth." Indeed, the company did post strong growth in digital-cable sales, although growth in cable telephone slowed from the fourth quarter.

AT&T Chairman Mike Armstrong agrees that the broadband unit's margins "are simply too low and must improve." But, he said, cost cuts and consolidation of some regional operations are already working.

The executives are not backing off their forecast that the cable unit's margin for the full year will total 23% and get much better in years to come.

Cable is far from AT&T's only problem child. Sales in the company's core consumer long-distance unit dropped 20%, while revenue for its once-vaunted business-services division fell 1%.

It's not as if AT&T Broadband weren't increasing revenue. The unit posted an 11% increase in revenue for the three months ended March 31, with average monthly sales per subscriber hitting $51.56. But cash flow dropped 22%, to a mere $8.65 per subscriber per month. For all the criticism AT&T executives have levied on how poorly TCI's management ran and maintained its systems, AT&T is now squeezing 45% less cash flow out of each cable subscriber despite generating 30% more revenue.

AT&T executives blame the reduced first-quarter cash flow on the cost of rolling out broadband telephony, higher programming expenses and increased restructuring charges from recent layoffs. But even excluding the $56 million in restructuring charges would boost AT&T Broadband's margin only to 18%. Advertising and pay-per-view sales also dropped.

One factor behind the margin decline is the pending sale of its small-town cable systems. Those were some of the highest-margin properties in the corporation's portfolio, partly because they were rural and partly because AT&T has focused its spending on large-market clusters. Divesting those systems drags AT&T Broadband's margin down.

But product launches are expensive. Somers said the company added 700,000 "RGUs," or revenue-generating units, during the quarter. About 150,000 of those were telephone customers that are costly to hook up.

However, the pace of sales of all three advanced services—phone, high-speed data and video—slowed in the first quarter. During the three months ended Dec. 31, AT&T added 205,000 cable phone customers; in the following three months, it added 25% fewer. The signup rate for data customers plunged 15% from fourth to first quarter, from 239,000 to 206,000, and connections of digital subscribers fell 4%, from 354,000 to 340.000.

That doesn't bother Morgan Stanley analyst Richard Bilotti. "I was actually most surprised by the digital number; I had been worried about that. But the margins are a problem."