As appeared in U.S.News and World Report, April 15, 1996 (1267 words)

Look who's talking

The first baby bell merger should lead to more telecom deal discussions


The federal government spent 10 years breaking up AT&T's telephone monopoly. The move spawned seven new phone companies, and consumers benefited from competition in the long-distance market because of lower prices. But last week, the telecommunications industry experienced DEJA VU as two of Ma Bell's offspring announced that they were reuniting. In a $16.7 billion deal--the first merger between Baby Bells and the fourth-biggest ever--SBC Communications, headquartered in San Antonio, acquired Pacific Telesis, the local telephone company in California and Nevada. The transaction will create the nation's second-largest telecommunications company, behind AT&T.

Many analysts believe that the SBC-Pacific Telesis linkup is just the beginning of a huge wave of new consolidations and partnerships that will transform the communications world. Sparking the activity is the sweeping telecommunications law that Congress passed two months ago. The act permits the Baby Bells to expand beyond their regional bases into the national marketplace. Now, these players can offer phone service and sell a panoply of new products--including long distance, cable, video-on-demand and futuristic wireless phones--from coast to coast. In return, the long-distance giants and cable companies will be allowed to invade the Baby Bells' local phone business.

FIGHT.The Baby Bells say they're eager to mix it up in this commercial free-for-all. But the fracas will be bruising. Nearly all the regional phone companies have cellular franchises, and most have tested new video systems. But analysts aren't certain which advanced services will generate meaningful profits. As a result, retooling for an unpredictable future has been difficult. The Baby Bells, for example, have slashed roughly 100,000 jobs since 1990, and many more positions are likely to be cut in the years ahead as the regional phone companies strive to compete.

Baby Bell employees aren't the only ones who have had trouble adjusting to the new telecommunications environment. Investors who have plowed money into the regional phone companies have seen dividend growth plummet. The Baby Bells' annual dividend increases, which averaged 6.4 percent between 1988 and 1991, have dropped to just 2 percent over the past four years. In fact, just before its merger, Pacific Telesis announced a 42 percent dividend cut--the first dividend reduction by a Baby Bell.

Long-distance phone companies are also feeling pressure on Wall Street. In an effort to boost its lagging shares, which are off 2.9 percent so far this year, AT&T decided to split itself into three companies. Last week, its equipment arm, Lucent Technologies, went public and raised $3 billion in the largest initial public offering of a spinoff in history. With $21 billion in revenues, Lucent is one the biggest equipment manufacturers in the world. But some industry analysts fear that AT&T might have detached a key company resource since roughly three quarters of the scientists at the renowned Bell Labs will join Lucent. Still, the market viewed the spinoff positively, and Lucent shares jumped from $27 to $30.63 by week's end.

MARKETS. With so much unpredictability, it's not surprising that SBC and Pacific Telesis have decided to merge. SBC is considered one of the more successful Baby Bells because of its diversification. About 37 percent of its revenues come from nontraditional businesses such as wireless phones. But without a New York, Chicago or Los Angeles in its operating region, SBC lacked major earnings power. Now that it has joined with Pacific Telesis, it hopes to reap benefits from the lucrative California market. For its part, Pacific Telesis has turned in a soft performance despite operating in solid markets. Competition arrived early in California and hit Pacific Telesis hard. Last year, for example, the company lost 39 percent of the revenues it derives from in-state long-distance toll calls. In addition, Pacific Telesis's decision to spin off its cellular unit removed a growing business from its balance sheet. As a result, the company's overall 1995 revenues dropped 2.1 percent--one of the worst performances among the Baby Bells.

The merger should improve those numbers. Both SBC and Pacific Telesis are based in regions with large and growing ethnic populations. This demographic advantage could help the combined entity market long-distance service to Latin America and Asia. Long-distance profit margins are six times bigger than those for local calls, and the market is booming. Kevin Moore, an analyst at Alex. Brown, estimates that basic long distance revenues will grow at a 2.5 percent rate this year, but international long-distance revenues will jump 15 percent.

So which Baby Bells will merge next? Nobody knows for sure, but geography will certainly play a key role. In terms of market size, U S West received the least favorable territory after AT&T's breakup. The $9.5 billion company operates in 14 western states, but many of them are sparsely populated, and Phoenix is the only city that ranks in the nation's top 20. With fewer growth opportunities in its region, U S West is looking elsewhere for its future. The Baby Bell owns a 25 percent stake in Time Warner Entertainment, and it recently paid $10.8 billion to acquire Continental Cablevision, the country's third-largest cable service. U S West hopes to use this deal to offer nationwide phone service within three years. This strategy will involve huge costs because the regional phone company--which already has the highest debt-to-capital ratio among the Baby Bells--must spend more money to upgrade Continental's cable wires.

BellSouth, unlike U S West, operates in one of the fastest-growing parts of the country. With 21 million access lines, $17.9 billion in revenues and the only AAA credit rating among the Baby Bells, this regional phone company is focusing on business in its own territory. The new telecommunications law will further boost BellSouth's profitability. In the past, for example, the company was prohibited from including advertisements for its cellular service in monthly bills; now, BellSouth can send marketing information to its customers every month and try to get people to test its advanced, higher-margin services. Explains William Reddersen, group president of long-distance and video services at BellSouth: ``Our fundamental plan is to serve our existing customers. Some day we'll go out.''

CASH.When BellSouth decides to venture beyond its region, it could use its considerable cash clout to acquire a long-distance company or another Baby Bell. One rumored match might be with U S West, which could benefit from BellSouth's strong financial position. So far, Bell Atlantic and NYNEX are the only Baby Bells to have openly admitted merger talks. If these two regional phone companies were to combine, they would create a telecommunications behemoth that would dominate the Northeast and mid-Atlantic regions. Unlike Bell Atlantic or NYNEX, Chicago-based Ameritech hasn't aggressively reached out to partners, although it certainly has a balance sheet that would permit a major deal. Ultimately, however, if the Baby Bells are going to grow from regional monopolies to national telecommunications players, mergers will have to take place. ``None of these companies is powerful enough to dominate,'' notes telecommunications consultant Herschel Shosteck. ``And the outcome of all the moves will be fewer and stronger competitors.''

While they weigh merger possibilities, the regional phone companies must keep a sharp eye on rivals in other sectors of the communications industry. Alternative access providers, for example, have siphoned off profitable business customers from the Baby Bells in many major cities. In addition, the long-distance giants are busy building transmission capabilities to carry local telephone calls. And cable companies and utilities could also join the phone fray.

With so much competition coming from so many different directions today, the Baby Bells are being forced to mature in a hurry. Their adolescence could be painful.

With Bernard Yee in New York. Copyright 1996, U.S. News & World Report. All rights reserved.

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