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Bell Ringer!


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BELL-RINGER!

The largest communications merger in American history started in the basement of Ray Smith's townhouse outside Washington. One evening last June, the chairman of Bell Atlantic Corp. gathered three of his top executives around a card table. Their agenda: to chart a new course for the Baby Bell. Bell Atlantic was no laggard among the regional phone companies. The company was more innovative than the other six Baby Bells in areas such as video services. Yet Smith wasn't satisfied: "What do we need to do to change the nature of this business?" he asked.

The team batted around several ideas about how Bell Atlantic could break out of its comfortable, but confining, business. "We kept coming back to the same conclusion--that we needed a cable partner," Smith recalls. For Raymond W. Smith, the candidate was obvious: Tele-Communications Inc., the nation's largest cable operator, with about 13.2 million subscribers.

One month earlier, Smith had contacted TCI's chief executive, John C. Malone, about ways the two companies could collaborate. Malone, the cable business warlord renowned for his bare-knuckles tactics and maverick sensibility, was seeking ways to launch TCI into the telephone business. Malone got on well with Smith, an affable Bell System lifer who spends his spare time directing in community theater (page 37). Smith's Bell Atlantic, Malone says, was the only phone company aggressive enough for his taste.

What followed was a round of meetings in Denver, Washington, and New York. The executives were so secretive that even in one-on-one sessions, they referred to their companies by code names: Shamrock for Bell Atlantic and Ireland for TCI. At one point, Smith flew to Malone's summer house on the coast of Maine. During a long cruise on Malone's yacht, the two began hammering out the terms of a deal. "We were trying to determine what the threshold of pain was," says Malone.

The conclusion: Bell Atlantic would buy TCI and its cable-programming sister, Liberty Media Corp., for stock valued at roughly $12 billion. Moreover, the phone company would absorb TCI's and Liberty's mammoth $9.6 billion in debt. Malone would become vice-chairman of Bell Atlantic under Smith.

Still, the work was not done. Each company had to determine what it was willing to commit in order for the merg

er to go through. Under the accord they finally reached, Bell Atlantic will end up paying TCI a hefty premium on its stock, which, among other things, could catapult Malone into the ranks of media billionaires. The acquisition could depress Bell Atlantic's profits for years. At the same time, Malone, who built TCI from a lackluster assortment of rural cable systems into a formidable media giant, will cede control to Smith.

Even after those weighty issues were resolved, the companies worked furiously to tie up loose ends before making a simultaneous announcement in New York and Washington on Oct. 13. Amazingly, in the rumor-riddled media world--where every company is said to be wooing another--news of this union did not leak out until the night before.

And what a union it is. The new Bell Atlantic will boast more than 22 million cable and phone customers in 59 of the top 100 U.S. markets (table, page 34). Through TCI and Liberty, the company will own major equity stakes in a staggering variety of media franchises, including Turner Broadcasting System, Home Shopping Network, and the Encore pay-TV service. And now, Bell Atlantic could challenge every other American phone company for local service: The two companies plan to rebuild TCI's cable systems for phone service while turning Bell Atlantic's telephone network into an enormous video pipeline.

THE BIGGEST WORRY. The megamerger could still founder, of course. Though trustbusters' quick, back-of-the-envelope view is that it will pass regulatory hurdles, at least parts of the deal could be scuttled by regulatory pressure or legal challenges. And some Wall Streeters are already suggesting that a rival bid could emerge, most likely from one of Bell Atlantic's Baby Bell competitors. Indeed, it could provoke a 1980s style bidding war, like the one for Paramount Communications Inc. in which Malone, among others, has been involved (page 39). At the very least, the deal will force every other cable and telephone company to consider alliances of their own (page 38).

But the bigger worry may be the potential for management squabbles as the two companies try to merge. Malone, says he will stay in the background and let Smith operate the company. But Malone and fellow TCI executive Robert Magness will own about 4% of the new company's shares, making them its biggest shareholders. And Malone, who's hardly a shrinking violet, may quickly start to chafe at his secondary role. If conflicts do emerge, they could run deep: The merging companies have highly divergent corporate cultures. Philadelphia-based Bell Atlantic is steeped in the tradition of the highly regulated, cautious Bell System. TCI, based near Denver, epitomizes the freewheeling, cowboy opportunism of the cable industry.

If the merger comes off as planned, however, those wondering when the concrete would be poured for the information superhighway needn't look any further. Smith's and Malone's deal is the boldest gamble yet on the coming convergence of computers, communications, and media. This odd couple agree on one thing for sure: They want to bring you a revolution in home entertainment and information. Bell Atlantic says it will be able to provide consumers with everything from video phone calls and long-distance learning to telemedicine and films at the touch of a button. What's more, Bell Atlantic could use TCI's cable systems as a network to construct a new generation of wireless phone service, called Personal Communications Services. The company plans to bid aggressively for the rights to PCS in government auctions scheduled for next year.

As rival communications companies and government regulators sifted through the implications of the Oct. 13 announcement, some were almost at a loss for words. James H. Quello, chairman of the Federal Communications Commission, calls the merger "the most momentous deal of the decade in a decade of huge mergers, acquisitions, and joint ventures." Adds the chief executive of a rival cable company: "This shuffles everything so thoroughly that I can't even begin to think about it."

Indeed, the deal dwarfs other much-trumpeted communications alliances of recent years, such as US West Inc.'s $2.5 billion investment in Time Warner Inc. and Nynex Corp.'s recent $1.2 billion stake in Viacom Inc. If debt is figured into the purchase price of TCI, Bell Atlantic's bid even tops Time Inc.'s $14 billion purchase of Warner Communications Inc. in 1989. Wall Street sources estimate that Salomon Brothers Inc., which represents Bell Atlantic, may net $20 million in fees. Incredibly, Malone acts as his own adviser.

Not the least of the merger imponderables is its implication for the Paramount bidding war. Malone supports Barry Diller's effort to wrest Paramount away from Viacom, which announced an $8.2 billion merger with the entertainment giant on Sept. 12. Diller's company, QVC Network Inc., countered with $9.5 billion in stock and cash. And Paramount's board has agreed to informal talks with him. Liberty Media owns 22% of QVC and has stocked Diller's war chest with $500 million.

RUFFLED FEATHERS. Malone says he still backs Diller's campaign. But he calls Paramount a "peripheral" investment for a company with combined revenues of $15 billion. And he didn't even inform Diller until two days before the announcement. Though it was interested earlier, Bell Atlantic says it won't make a direct investment in QVC's bid for Paramount. Should Diller prevail, though, the combined Bell Atlantic-TCI would own 9% of Paramount, thanks to Liberty's stake in QVC.

Diller may not be the only one with ruffled feathers. Bell Atlantic's move is sure to prompt a blizzard of inquiries from concerned lawmakers and regulators in Washington. Representative Edward J. Markey (D-Mass.), who heads a key communications subcommittee, says he has asked the FCC to launch a formal investigation into potential "market bottlenecks" resulting from such giant combinations. Viacom, which filed an antitrust suit against Malone earlier in the Paramount takeover battle, says the Bell Atlantic deal raises more "troubling questions" about his dominance of the cable and entertainment markets.

And the deal adds new urgency to congressional bills that would reexamine laws restricting cable and phone companies from entering each other's businesses. In fact, Bell Atlantic must win court waivers from the terms of the 1982 breakup of the Bell System in order to pull off the TCI purchase. That's because the satellite distribution system used by cable operators such as TCI to send shows around the country is considered a form of long-distance service, prohibited by those rules. "I think [lawmakers] are going to be forced by this merger to decide once and for all how they feel about the whole telco-cable arena," says Richard E. Wiley, a leading communications lawyer.

With his 13.2 million cable subscribers and ownership stakes in several cable networks, Malone has clashed repeatedly with government regulators. And his tough tactics have earned him the enmity of heavy hitters such as Vice-President Al Gore. Smith, meanwhile, has been far quieter, though no less aggressive, in his testing of regulations.

Congress has historically prohibited telephone companies from providing

video services or owning cable systems in their service region. For now, Smith isn't challenging the ban on cable systems: He plans to sell off all TCI cable systems in the Bell Atlantic region. That affects approximately 1.6 million TCI subscribers. But Smith is contesting the prohibition on video services. And Bell Atlantic won a U.S. District Court case in August that gave it the right to offer video programming in its phone-service territory. The government may appeal.

SHOPPING MALL. Smith, meanwhile, is forging ahead. In Arlington, Va., he is testing a novel technology that allows the phone company to pump movies and TV shows through old-fashioned copper lines into consumers' TV sets. If perfected, the technique could allow Bell Atlantic to forgo the costly rewiring of homes with coaxial cable or fiber-optic lines. Meanwhile, in neighboring Alexandria, Bell Atlantic is doing just that: It is rewiring the entire city with fiber lines that it will use to provide a direct challenge to the city's monopoly cable-TV system as well as to improve ordinary phone services--and mount a direct challenge to the monopoly cable-TV system.

But Bell Atlantic's video plans go beyond just an advanced infrastructure. It also wants to become a programming powerhouse in the new world of interactive media. It is pouring an estimated $40 million a year into developing an electronic navigation system for interactive TV services. Called Stargazer, the sophisticated system could appear on TV screens in the homes of both Bell Atlantic and TCI customers in coming years. Using an on-screen motif of a shopping mall, it will offer consumers easy access to home shopping, banking, education, and other interactive services. And Bell Atlantic already is working with key programmers, such as Walt Disney, Paramount Pictures and Home Box Office, in the Arlington test.

Bold as it is, Bell Atlantic's deal with TCI is not without risks. Aside from the possibility that a rival bidder for TCI could emerge, Bell Atlantic is hardly the only company gunning for the interactive future. Indeed, nearly every media, computer and communications concern believes it will be a leader in the field. Computer and software giants such as Microsoft, Apple, and IBM will rival Bell Atlantic with programming navigation systems, while Time Warner, Viacom, and other cable contenders plan to build their own interactive systems--in conjunction with phone-company partners. And new challengers will appear. The next few years could be a free-for-all as the various contenders invade each others' markets.

Already, Wall Street is eagerly awaiting more deals between cable and phone companies. Shares of cable operators such as Comcast Corp. and Cablevision Systems Corp. zoomed on Oct. 13 on the expectation that they may also be bought by phone companies. Meantime, QVC's Diller continues talks with BellSouth Corp. about a major investment in his bid for Paramount. And Nynex recently paid $1.2 billion to be part of Viacom's effort, while Southwestern Bell Corp. has spent $650 million to buy just two suburban Washington cable systems. Says Abby Johnson, a portfolio manager at Fidelity Invest-ments: "What people are realizing is that everybody had better hurry up and get together and pair off."

Telephone companies may not restrict their investments to cable. Hollywood moguls say some phone companies have also expressed interest in owning equity stakes in studios. Among those willing to hear offers: Sony Corp. of America, which owns Columbia Pictures and Tri-Star. "This is like a game of musical chairs," says Sony President Michael P. Schulhof. "Nobody wants to be without a chair when the music stops. And we own one of the chairs."

About the only phone company that may stay out of the deal game is American Telephone & Telegraph Co., which insists it has no plans to own all or part of a cable company or programmer. Instead, AT&T perceives its role both as a provider of advanced equipment for interactive video networks and as a "wholesaler" of video service. It plans to upgrade its long-distance network so it can store and forward video programming for local service providers such as Bell Atlantic or TCI.

What made Malone so attractive to Bell Atlantic is that he straddles the worlds of cable distribution and programming. Indeed, Malone has garnered equity stakes in an array of cable services such as the Discovery Network's Learning Channel. He also was a leader in the 1987 bailout of Turner Broadcasting System Inc., gaining at the time a 23% stake in TBS.

By 1991, though, Malone was feeling heat from regulators about the number of cable-programming services under TCI's sway. So he spun off the programming into a new company called Liberty Media and became chairman and owner of 51% of its stock. As its shares zoomed, Malone's equity and options jumped to $700 million. Then, says Malone, the government's reregulation of cable turned out not to be so onerous

after all.

At that point, Malone began contemplating a recombination of Liberty and TCI. He had a powerful incentive: Though few knew it at the time, TCI was already far along in its talks with Bell Atlantic. And Malone knew he could extract a better price for TCI with its rich programming assets. On Oct. 6, TCI said it would buy back Liberty in a stock swap worth $3.5 billion. And a few days later, Bell Atlantic offered $35 for each share of TCI, placing a value of $11.8 billion on TCI and Liberty.

BLANK CHECKBOOK. One big winner in all this is John Malone. His $700 million stake in Liberty is now worth close to $1 billion. Some media analysts question why Malone is getting a 10% premium on his Class B shares of TCI stock when Class A shareholders are not. Malone argues that he deserves the premium because he will hold his shares for up to five years.

As vice-chairman, Malone says he will serve as the house visionary for Bell Atlantic. And despite his take-charge reputation, he says he welcomes a reduction of his day-to-day responsibilities. Media analysts agree Malone is in an eviable position: "He has been given a checkbook to go out and look for new ventures," says John Tinker, a media analyst at Furman Selz Inc., "while Ray Smith will look after the more mature businesses." That certainly underestimates Smith's role in the new company. But clearly, Smith and Malone are one of the most interesting tandems in American business.

Right now, what binds Smith and Malone together is their vaulting ambition for the ways digital technology can be harnessed to revolutionize home entertainment and information. If they can navigate the regulatory shoals and avoid boardroom strife, the maverick entrepreneur behind TCI and the genial company man atop Bell Atlantic just may have created the first true 21st-century communications company.THE PROS AND CONS OF THE BELL ATLANTIC-TCI DEAL

THE PLUS SIDE

A PANOPLY Using digital technology,

OF SERVICES the two companies can offer a host of new interactive products,

from movies on demand to long-distance learning to home

shopping.

CAPITAL Bell Atlantic can use its cash

STRENGTH flow and borrowing power to upgrade its telecommunications

network for video services and to add phone capabilities to

TCI's cable network.

MARKET Together, the two companies

BREADTH have access to 22 million customers and a presence in 59 of the

top 100 U.S. markets, giving Bell Atlantic a broader base than

any other Baby Bell.

POTENTIAL PROBLEMS

REGULATORY Government concerns are

HANGUPS likely to center on whether a phone company should offer video

services in its region, something previously prohibited. One

fear: Bell Atlantic could use its regulated phone profits to

subsidize fast-growing video and other services.

DUPLICATION To avoid political fallout and

OF SERVICES possible regulatory hassles, TCI plans to divest itself of the

14% of its 13.2 million subscribers who are in Bell Atlantic's

territory.

MANAGEMENT John Malone, TCI's chief,

CONFLICTS promises as vice-chairman of the merged company to mainly advise

Bell Atlantic's Raymond Smith, who remains CEO. But Malone will

be the new company's biggest shareholder and he may not take

a back seat for long.

DATA: COMPANY REPORTS, BUSINESS WEEK

Mark Landler and Bart Ziegler in New York, with Mark Lewyn in Washington, Leah Nathans Spiro in New York, and bureau reports


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