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Rewired And Ready For Combat


Editor's note: The Justice Dept. on Oct. 27 gave a green light to Verizon's planned purchase of MCI and SBC's proposed AT&T acquisition on the condition that each divest certain fiber-optic network connections. The Federal Communications Commission on Oct. 28 postponed a decision on whether to clear the deals.

On a crisp September afternoon, Edward E. Whitacre Jr. bursts into a conference room on the 13th floor of the Ritz Carlton Hotel in Chicago. The CEO of SBC Communications Inc. () is taking a break from a meeting with his board of directors, and he's in an upbeat mood. The 6-foot, 4-inch exec is a big football fan, and his alma mater, Texas Tech, is undefeated. "Undefeated!" he says. "Although I don't think we can keep winning 80 to nothing." (The final tally against Sam Houston State had actually been 80-21.)

When the conversation turns to the state of the telecom industry, his mood darkens. Cable companies and Internet upstarts are swiping millions of customers from SBC and other old-line phone companies. Just a few days earlier online auctioneer eBay Inc. () had agreed to pay $2.6 billion for Skype Technologies, a Luxembourg startup that lets people make free phone calls over the Net. Pressed on the threat from these Web upstarts, Whitacre leans forward in his chair and raises his voice. "They don't have any fiber out there. They don't have any wires. They don't have anything," he argues. "They use my lines for free -- and that's bull. For a Google () or a Yahoo! () or a Vonage or anybody to expect to use these pipes for free is nuts!"

A little defensive? Well, sure. Over the past 10 years, SBC and Verizon Communications Inc. () have spent tens of billions of dollars building telecom empires so they could dominate the industry. Thanks to their string of megadeals, SBC and Verizon have become far and away the largest telecom players in the land, together controlling nearly two-thirds of all residential phone lines in the U.S.

But now a flock of rivals, including Skype, is threatening to wipe out the value of all those phone lines. They're using Internet technology to offer comparable calling services at half the price, without owning a single foot of telephone wire. In a recent report, analyst Anthony Noto of Goldman Sachs & Co. () titled one section on the prospects for phone companies "The roadmap to the destruction of value." He wrote that they could lose 40% of their land-line residential customers over the next 10 years. Verizon's stock is down 21% for the year, to $30, while SBC shares have slipped 3%, to about $24.

So what are SBC and Verizon doing about all this? The companies' chief executives don't deny the seriousness of the threat. They may quibble with the pace of the decline, but neither doubts that their traditional phone businesses are history. So they're busy overhauling their operations to prepare for the new era. Both say that their futures depend on how well they perform in broadband, wireless, video, and corporate services. "We're not sitting back and waiting for the world to kill us," says Ivan G. Seidenberg, Verizon's chairman and CEO. "Before we get suicidal, we need to apply some adult thinking to this. It's not the death of anything. It just forces us to change faster."

The changes are already under way. As early as Oct. 28 the Justice Dept. and the Federal Communications Commission are expected to give SBC the green light to acquire AT&T () and Verizon approval to buy MCI (). The agencies may require several concessions, including the divestiture of some assets. The purchases will make SBC and Verizon much more important providers of communication services to corporations since AT&T and MCI are the largest players in that market.

Essentially, Verizon and SBC are trying to pull off a tricky balancing act. They need to boost revenues from their new services faster than their old businesses fade away. So far that has worked out fine. Wireless and broadband services have been more than enough to replace the decline in traditional voice. But the slide in voice is expected to accelerate in the years ahead, and the wireless business is growing more challenging.

Cable companies, which have been offering local phone service over their fiber lines, haven't been able to sell wireless service because they don't own such networks. But on Oct. 24, Comcast Corp. () confirmed that it's negotiating with Sprint Nextel Corp. to use Sprint's network to sell wireless service. Time Warner Inc. () and Cox Communications Inc. are expected to strike similar deals with Sprint. Even Net companies such as Vonage Holdings Corp. are gearing up for wireless offerings of their own. This burst of new competition could crimp profits since it comes just as wireless growth is slowing. Researcher Sanford C. Bernstein & Co. () expects annual wireless growth to drop from an average of 15% over the past five years to 6% annually over the next five.

It's little wonder, then, that Wall Street sees bleak years ahead. Citigroup Global Markets Inc. () expects Verizon, which will have revenues of $93 billion with MCI, to boost that a mere 1% annually for the next few years. The situation could be worse for SBC because AT&T, which, like MCI, is shrinking, is a bigger company. Citigroup () predicts that SBC'S revenues, $99 billion with its Cingular Wireless joint venture and AT&T, will slip an average of 1% over the next few years.

GIANT VS. GIANT

To goose their growth prospects, Whitacre and Seidenberg know they need to move aggressively into new markets. The most important will be corporate services, TV, and broadband, including Internet telephone service similar to the kind that upstarts such as Vonage are offering. These can be pricey undertakings. Verizon plans to invest at least $10 billion to lay fiber-optic lines to millions of homes so it can offer extra-fast Net connections and TV services. Seidenberg vows the investments will be well worth it. "What is the total cable and media industry worth? $120 billion? That sounds like free money to us," he says.

The two giants will be pushed into tangling with each other more than ever before, too. They've already stepped up their rivalry in wireless. Next, with the acquisitions of AT&T and MCI, will come corporate services and Internet calling. Net technology is now developed enough that it will be easy for Whitacre and Seidenberg to compete for customers in each other's territories. AT&T has already been pushing Internet calling, so once SBC closes its deal, it will be in direct competition with Verizon in all of its top markets, including New York, Philadelphia, Boston, and Los Angeles. "We're fixing to get into [Internet phone service] big time once the AT&T acquisition is done," says Whitacre. Competition with Verizon, he adds, "will pick up a lot."

The struggle offers an intriguing contrast in styles. Whitacre, called "Big Ed" inside SBC, is known for his aggressive ways. Through a string of acquisitions over the past 10 years, he has transformed the smallest Baby Bell into what will be the biggest telecom company after the AT&T deal closes. Cingular, a joint venture with BellSouth () in which SBC owns 60%, became the largest wireless player after acquiring AT&T Wireless last year. Over the years, Whitacre frequently talked about wanting to build the biggest player in the industry, and he planned to rename his company AT&T on Oct. 27, reclaiming the Ma Bell mantle.

Seidenberg, a Bronx native, is more understated. He downplays the prospect of more rivalry with Whitacre and says: "It's not important to me who's got bigger marbles." He tends to manage through consensus rather than fiat. When Seidenberg merged his NYNEX with Bell Atlantic and then GTE, he gave up the chief executive post twice, submerging his own ambition to smooth the corporate integrations. In contrast, Whitacre negotiated the exits of chief executives at Pacific Telesis Group and Ameritech when he bought those companies so he could run the show on his own.

How the telecom titans manage their way through these difficult times will help define what the communications industry looks like in the years ahead. If they succeed in their efforts, U.S. consumers could surf the Internet from their couches and pull up video Web sites as easily as they now get cable channels. Wireless phone service could become as advanced as in any part of the world. And corporate customers will see new combinations of wireless and traditional calling. But if Whitacre and Seidenberg stumble, they may pull back on their investments and put off the introduction of new services. "You're talking about the industry's 800-pound gorillas. They'll play a big role in how much innovation occurs," says Raul Katz, chief executive at consultant Adventis Corp.

NEW TV FEATURES

Perhaps the most important, and challenging, foray for the two men is the television business. Comcast and the other cable companies have swiped 4.4 million phone customers, and the figure continues to rise. So getting into TV is about more than providing Verizon and SBC with the opportunity for new revenues. It's a defensive move that will let them offer customers the same bundles of voice and video that the cable players do. "They've got to do it," says analyst John C. Hodulik of UBS () Securities. "The cable industry has already proven it can take share in the voice market."

Seidenberg and Whitacre have somewhat different approaches to the TV market. Seidenberg is pursuing a more expensive route, stringing fiber-optic lines directly into people's homes. Whitacre is running fiber into neighborhoods and using the existing copper from there to deliver video. He figures that'll let him get into the television business more quickly and cheaply than Verizon. Whitacre expects to hook up about 18 million homes over the next three years for $5 billion. Analysts think Verizon will have to spend the same amount of money and time to hit 10 million homes. "I didn't want to tear up everybody's driveways and streets," says Whitacre.

Both companies say they plan to bring more innovation to the television world. Ernest J. Carey, SBC's vice-president for advanced network technologies, offered a sneak peak of his company's TV service in its downtown San Antonio offices. It includes several features not available on standard cable television. One of them, called "browse," lets users change channels and see the new program in a small window while the old program runs in the background with the audio. Another feature will allow you to create your own channel, stocking it with prerecorded or live shows. SBC plans to launch the service broadly next year.

Verizon, which is offering its TV service in one market so far, is pushing innovative features, too. Chris Kroeger, a resident of Keller, Tex., who recently switched from Dish Network () to Verizon TV, says he likes that he can watch one show and record another, something he couldn't do before. He also gets more channels and more choice of on-demand video than he did with Dish.

Verizon's early efforts offer some promise. Since it began marketing TV service in Keller in September, Verizon has signed up 25% of the customers in that market -- hitting the high end of its goal in a matter of weeks. The cable giants have noticed. "We take [the threat from phone companies] very seriously," says Comcast CEO Brian L. Roberts. UBS' Hodulik predicts that by 2010, Verizon will get $2.2 billion in revenues from video, and SBC will pull in $1.8 billion.

Whitacre and Seidenberg will slug it out with the cable companies in the broadband market, too. So far the cable players have had the lead in supplying speedy Internet connections to consumers. By offering lower prices and higher speeds, they've signed up about 22 million U.S. households out of a total of 39 million that have broadband.

But now SBC and Verizon are getting more aggressive. Both companies have dropped their prices for broadband to as low as $15 a month and are cranking up speeds. Verizon is beginning to use its new fiber to offer Net connections of as much as 30 megabits -- 10 times as fast as standard cable service and 20 times that of most phone-company service. Some analysts think that will help them close the gap with cable rivals. UBS expects telecom companies to end 2005 with 45% of broadband customers, up from 42% last year. Today, SBC is the No. 2 broadband provider in the country, with 6.5 million customers, behind Comcast. Verizon has 4.1 million broadband subscribers.

The critical battle will be over the 30 million to 35 million households that still have dial-up Internet service and are likely to switch to broadband over the next few years. That market is worth $10 billion to $14 billion in broadband fees alone.

Seidenberg, for one, believes broadband service is just the start. Once Verizon has that kind of pipe into customers' homes, he figures the company will be able to sell all sorts of extras. On a recent fall day in his office in Manhattan, the normally sedate CEO bounds out of his chair to show off one such possibility. It's something called Verizon One Phone, which looks like an oversize office phone with an extra-large color screen and a cordless handset. Seidenberg fiddles with the keys and demonstrates that the phone can collect voice mail from your wireless and wire-line phones, e-mail from your computer, and updates from the Web on local weather and news. "That's innovation," beams Seidenberg. "We think broadband will eventually create new revenue streams for us the same way wireless created new revenue streams for us over the last 10 years."

CORPORATE PUSH

New revenues will be difficult to come by in the corporate market. As SBC and Verizon close on their acquisitions of AT&T and MCI, they'll be taking over businesses that have been in steep decline for years. AT&T is expected to see revenues drop 13% this year, to $26.5 billion, while its net income hits $1.4 billion, predicts Citigroup. MCI's revenues are expected to slide 10%, to $18.5 billion, on earnings of $32 million. While the companies are best known for selling long-distance phone service to consumers, Whitacre and Seidenberg are buying them because they sell sophisticated services to companies, including consulting and security for computer networks.

Seidenberg says he hopes to stem the revenue decline by selling more wireless services to MCI customers. The idea is that corporate customers would get everything from consolidated bills to the ability to track internal packages with global-positioning technology. "We like the idea of how the two groups complement each other," says Peter Whatnell, chief information officer at Sunoco Inc. ().

There's another benefit to the acquisitions that Whitacre and Seidenberg are less vocal about. After the mergers, their two companies will control about 80% of the market for corporate services, compared with the 65% that MCI and AT&T had between them. Some analysts think that will help stabilize prices in the corporate market. But it has prompted howls of protests from the few remaining rivals, who believe the acquisitions will undercut competition. "The proposed mergers are bad for the business community," says Heather Burnett Gold, senior vice-president for government relations at XO Communications Inc. (), a provider of corporate telecom services. "Companies are seriously concerned about the impact of the mergers on rates, innovation, and service quality." Such concerns are one reason the Justice Dept. may require divestitures or other concessions before approving the mergers.

Of course, cable companies and Internet startups are working on plenty of new tricks. Comcast's Roberts expects to offer Internet telephone services to half of the company's homes by yearend and all of them by the end of next year. "It's just the beginning," he says.

Back in Chicago, that's one thing Whitacre agrees with. Proclaiming the death of telecom misses the point, he says. His company is changing rapidly to tackle the competitive threats, and his efforts will change large swaths of the business world. "We have stayed focused and we've invested for the long term so the business survives and does well," he insists. "Anybody who would say otherwise is pulling something out of their eye."

By Spencer E. Ante in New York and Roger O. Crockett in Chicago


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