AT&T, BellSouth deal creates a giant, but cable isn’t scared

Just three days after cutting a $67 billion deal to buy BellSouth last week, AT&T Chairman Ed Whitacre got a precious gift from Washington. Key Congressional leaders agreed to allow the giant phone companies a national franchise license, essentially allowing AT&T and other telcos a painless entry into the cable industry’s core business of video services.

Cable operators howled. “This is a huge step backwards,” wailed Kyle McSlarrow, head of the National Cable Telecommunication Association. If the proposed bill passes, he said, the government would be “giving the Bell monopolies a special break and a deregulatory advantage over their competitors.”

Cable vs. Telco: By the Numbers
Cable is stealing phone customers at a faster rate than telcos are stealing video subscribers
2005E 2006E 2007E 2008E
Cable telephone5,1748,03710,99714,080
Telco video234871,2522,600
Internet Data Market
With telcos' deep discounting, DSL data services are growing faster than high-speed cable service
2005E (000) 2006E (000) 2007E (000) 2008E (000)
High-speed cable22,99726,32629,58132,593
SOURCE: UBS Securities' Aryeh Bourkoff and John Hodulik

The two events helped frame the escalating war between cable and telephone companies. As cable’s largest operators move to lure phone customers away from the likes of AT&T and Verizon, they are doing battle with formidable giants that are only getting larger. And, as their latest gains in Congress indicate, the telcos’ agility in the political arena may be pivotal in the multi-front fight ahead.

Whitacre is creating a Goliath like no other before it. If the BellSouth deal is approved—as even its critics expect—AT&T will become the world’s largest telecom company and the nation’s seventh-largest company of any kind. AT&T’s $120 billion in revenue will not be just six times more than the largest cable operator’s—Comcast—but will exceed the revenue of the entire cable industry.


The deal only increases AT&T’s power in telephone companies’ escalating war with cable. AT&T and Verizon are attacking operators’ key source of growth—high-speed and high-priced Internet service—as well as their core video business. After years of being handicapped by an old network anchored by thin, “twisted-pair” wires, the telcos are spending billions of dollars improving their networks to offer high-speed data and the same channels that operators still rely on for the bulk of their revenue.

AT&T is laying high-capacity optical fiber deeper into neighborhoods it serves in 13 states. Verizon is going even further with a vastly more expensive approach, pulling fiber all the way to individual homes. Last week, Verizon lit up its latest FiOS TV market, Hillsborough, Fla. The fiber-optic Internet service is also available in the suburbs of five other markets.

The spending is largely defensive. Technology is breaking telcos’ century-old lock on the phone business and threatening their core phone operations. Cellphone customers with a flood of minutes find they no longer need wired service. For those that do, high-speed data lines let cable operators offer reliable local and long-distance service for $35 a month. That’s far less than the average $55 telco customer bill. Voiceover-IP companies like Vonage and Skype steal even more customers.

AT&T and BellSouth have each lost about 8% of their residential lines over the past two years. Whitacre told analysts the deal is driven by “a realization by both companies that the world is changing and it is changing faster and faster, and the sooner we did this deal, the better off we would be.”

The BellSouth deal is part of a chain of acquisitions that Whitacre has used to nearly re-create the original empire that AT&T held before being broken up to settle a government antitrust suit. As chairman of Southwestern Bell Communications (SBC), over the past eight years, he has bought fellow Baby Bells Ameritech and PacBell, as well as independent Southern New England Telephone. Just three months ago, SBC bought former parent AT&T, then adopted its name.


Buying BellSouth doesn’t give AT&T instant new power against cable, but it does help steel the company for the fight. Lowering the combined companies’ costs will let AT&T push harder in the data business, where telephone companies’ low prices already help them beat cable in adding new customers. Adding BellSouth’s nine states could enable AT&T to spread the cost of centralized video facilities over a greater number of customers.

Still, top cable executives aren’t alarmed by the BellSouth deal. “I don’t see the difference between competing with an $80 billion company and a $120 billion company,” says Comcast President Steve Burke. “Getting bigger isn’t going to help address the fundamental problem of their residential phone business.”

Cox Communications President Pat Esser concurs, yet finds the sheer size of the new company annoying. “If a company covering 70 million homes isn’t too big, who is too big?” he asks. “This should demonstrate that they don’t need any help from Washington.” Like other cable-industry faithful, he bristles at telcos’ demands for regulatory relief—particularly in avoiding local cable franchises.

House Energy and Commerce Committee Chairman Joe Barton disagrees. The Republican from AT&T’s home state, Texas, cut a deal with other Congressional leaders to move a bill that would eliminate telephone companies’ need to secure town-by-town permission to launch video services. Currently, a cable operator or similar provider needs a franchise from each town. Securing them is a cumbersome process, and telephone proponents have been lobbying federal and state politicians for relief, saying it slows their entry into video. Cable lobbyists, in turn, counter that the telcos shouldn’t get special treatment and should face the same restrictions operators do. “Three words: level playing field,” says Esser.

Winning franchise relief is important to telcos because any delays favor cable. Because they have largely finished their $60 billion system upgrades, cable operators can steal millions more telephone customers while the Bells are still trying to get out of the video gate.


“There’s still a window where cable has the advantage,” says UBS media analyst Aryeh Bourkoff. He and UBS telecom analyst John Houdlik—who have created a Wall Street franchise out of the cable/telco fight—estimate that, in 2008, AT&T and Verizon will each have signed up just 1.2 million-1.3 million video subscribers. Meanwhile, cable operators are expected to add around 3 million phone customers each year, growing from 5.2 million today to 14.1 million.

The threat of telco video has helped crush cable stocks, which have dropped 20%-30% over the past year. Many on Wall Street are skeptical that the telcos’ video plans make financial sense. They’ve seen telcos make bold promises about taking on cable in the 1990s, in part to secure special treatment from legislators and regulators. Once they secured what they wanted from Congress in 1996, they scrapped their video plans and went away.

But the new threat is enough to scare investors away, which in turn makes it harder for cable operators to raise cash and make deals that would bolster their own expansion. That alone could be sufficient reward, says the CEO of one top-10 cable operator: “They’re so big that they can afford to lose hundreds of millions of dollars trying to slow us down.”

Video, however, is not the only driving force in the BellSouth takeover. First, Whitacre wants full control of Cingular Wireless. The cellphone company is a 60-40 partnership between AT&T (majority owner) and BellSouth. That limits AT&T’s ability to tap Cingular’s financial strength and hamstrings both companies in bundling wireless with residential phone services. Such bundles would minimize defections to cable phone offerings.

Another major driver is cost saving. Despite restructurings since the 2000 dotcom/telecom crash, telephone companies remain bloated: fixed costs are high, organizations are bureaucratic, computing costs are gigantic.

Telco operations are far more vast than those of media companies Even before the BellSouth deal, AT&T’s employee counts totaled 189,000; buying BellSouth could initially push AT&T’s headcount to 280,000. By comparison, all the cable operators in the country total just 170,000 employees, according to a 2003 report from consulting firm Bortz & Co.

AT&T’s headcount won’t be so high for long. The company says combining with BellSouth can trim 10,000 positions without affecting revenue. That’s in addition to the 26,000 targeted after earlier acquisitions.

There are more-redundant costs at Cingular. UBS analyst Hodulik estimates that the cellphone company spends $1.5 billion on advertising a year, around 60% of it in “brand-building.” Cingular will be renamed AT&T Wireless, letting the wireless company piggyback on the hundreds of millions of dollars that AT&T already spends promoting wireline services.

Nevertheless, the deal will mark a dramatic change in BellSouth’s hesitation over telco video and turn up the heat on cable operators. BellSouth has been notably quiet as Whitacre and Verizon CEO Ivan Seidenberg have declared video war on cable.

Just a week before cutting the deal, BellSouth Executive VP/CFO Pat Shannon told investors that the telco is actively upgrading its phone network to deliver faster data and voice services. He doesn’t see a way to justify the extra capital investment that video would require. “The reason we are going slow was that we’re still looking for the right business model,” he says. BellSouth’s video strategy is limited to keeping its customers away from cable by reselling DBS service DirecTV and a small wired video trial.

But AT&T officials do see a business model and are expected to push BellSouth ahead once they take over. AT&T Inc. COO Randall Stephenson argues that BellSouth’s fiber upgrade plans are “very complementary” to AT&T’s Lightspeed video venture. “They have been very aggressive in the past at pushing fiber deeper into their network,” Stephenson says, adding that it “gives us a lot of flexibility as we ramp Lightspeed in the legacy [AT&T/SBC] territory if we want to.”

Sanford, Bernstein & Co. cable analyst Craig Moffett takes a different view. He believes that BellSouth executives’ skepticism could persuade AT&T to slow its plans. “Very likely, they will end up with a set of corporate visions that will be a blend of the BellSouth side of the world and the AT&T side.”


DirecTV may actually suffer the most immediate injury. Like all the major telcos, BellSouth has been trying to imitate cable’s bundle of video, voice and data services by reselling DirecTV to its customers. That has been a boon for the DBS company, which has gained 570,000 customers from the arrangement, or about 4% of its 15.2 million-subscriber base.

But AT&T has a more intricate arrangement to resell DBS rival EchoStar. AT&T has secured 420,000 customers for EchoStar’s Dish Network, and analysts believe the company is likely to scrap BellSouth’s DirecTV agreement.

AT&T’s Stevenson acknowledges the obvious conflict. “When we close the transaction,” he says, “we will have to evaluate how we synchronize those and determine which direction to go.”