Disconnected

By John Greenwald

Ray Smith and John Malone were sitting in their respective offices last Tuesday, both watching the same show: a C-SPAN broadcast of the Federal Communications Commission hearing on cable-TV rates. Smith, the chairman of Bell Atlantic, was in his Arlington, Virginia, office; Malone, the boss of cable giant Tele-Communications Inc., was at TCI headquarters in Denver. Both executives were appalled as they watched the FCC announce a 7% reduction in cable rates, on top of a 10% rollback ordered last year. Malone immediately telephoned Smith. "Ray," Malone said in an emotionless voice, "this is a bigger hit than we thought." Responded Smith: "Can you fly to New York?"

By the time they met the next day in the midtown Manhattan offices of Bell Atlantic's law firm, Skadden, Arps, Slate, Meagher & Flom, Smith had calculated that the rate reduction would slash TCI's cash flow by $1.8 billion and thereby reduce the company's value by a comparable amount. But Malone wouldn't hear of it. "I will not sell my company at the bottom of the market," the cable executive said, "and you'd be crazy to pay more than top dollar with this level of uncertainty."

Smith made one last try. "Let's take the price off the table," he said. So for the next 45 minutes the conversation roamed over topics ranging from programming to regulations. But inevitably the talk returned to price. "It's no good," said the hard-edged Malone. "I can't cut another nickel." Responded Smith: "You're right."

In the end, the bold architects of the $33 billion deal, the largest communications merger in American history, with prospects of creating a corporate colossus extending telephone and cable-television wires into roughly one out of every four American households, simply got cold feet. And it was more than government regulations that pulled them apart. The price of their stocks was plunging, and doubts about the economic wisdom of the merger were on the rise. And the deal may have been too big and too hasty. Wall Street reacted with a 51.78-point drop in the stock market on Thursday.

The failure of the deal stirred speculation over the future of the much touted electronic superhighway, which is expected to bring into U.S. homes everything from video games, movies and news on demand to vast video shopping malls. The quest to build this highway has become the great preoccupation of the 1990s, and thus the TCI-Bell Atlantic breakup had a global resonance. The two companies combined would have been the single biggest highway builder, expecting to spend as much as $20 billion over five years toward the construction of an interactive system for American homes.

But the merger had been tottering for weeks. Three deadlines for a definitive agreement had already come and gone. The big problem was the slumping value of Bell Atlantic stock, which had dropped from 67 5/8 on Oct. 14 to 52 3/4 the day the deal collapsed. That was uncomfortably below the $54 a share that Bell Atlantic had pledged to pay for TCI. Malone, whose personal stake would have been worth more than $1 billion under the merger agreement, demanded more Bell Atlantic shares to offset the decline in price. But Smith, who noted that issuing more stock would dilute the value of existing holders' shares, refused to comply. "TCI is a great property," he recalled, "but we would have had to give away nearly half our company to do this deal."

Smith and Malone had been an odd couple from the start. Smith, 56, an amateur actor and playwright who turned Bell Atlantic into the most venturesome of the seven Baby Bells, had come up through the staid bureaucratic ranks of AT&T before its breakup in 1984. Malone, 52, is a strong-willed, publicity-averse entrepreneur with a Ph.D. in operations research who built the fledgling TCI into the country's largest cable operator, gaining a reputation for ruthlessness along the way.

Cultural differences between the two companies also aroused a measure of distrust. After the merger agreement in October, Malone presented Bell Atlantic with a list of 23 questions about its management and policymaking methods. Would, for example, the phone company consider cutting its dividend in order to plow more money into capital investment? Bell Atlantic wouldn't hear of it; like other big utilities, the firm considers large and steady dividends to be an important feature of its stock. Smith had at least 40 questions of his own. Could TCI deal with the intense level of regulatory scrutiny that Bell Atlantic was used to? Did TCI's cable executives have the flexibility to branch into other fields?

Despite the troubles, the two sides were close to bridging their differences shortly before the deal blew up. "I talked to John as late as Monday night," says John Hendricks, chairman of Discovery Communications, which operates the Discovery Channel and Learning Channel. "At that point the merger was on. There was some relief in his voice that they had finally arrived at a deal." The broken alliance may indeed slow the construction of a nationwide information system, but very few experts expect that it will stop it. Other cable firms and telephone companies continue to move forward with combined ventures of their own. Among them: Time Warner and U.S. West, which last May put up $2.5 billion for a 25% stake in Time Warner Entertainment, a unit of Time Warner that owns, among other things, cable outlets in 36 states. At the same time, Southwestern Bell and Cox Cable have teamed up to develop interactive TV systems of their own.

These companies aim to build on a trial basis in limited locations, rather than rushing ahead on a nationwide scale, as Bell Atlantic and TCI had planned to do. "The information highway will be constructed on the basis of consumer demand, rather than on the basis of build-it-and-they- will-come," says Steve Krause, a technology analyst with SRI International.

Still, the rollback of cable rates could slow the growth of cable companies and make them less attractive as merger partners. Falcon Cable TV, a Los Angeles-based company with 1.1 million cable subscribers, last week halted plans for a $125 million public offering in the wake of the FCC order. Falcon , had planned to use the funds to replace 2,300 miles of conventional wire with fiber-optic cable that could double its current 40-channel capacity. "The uncertainty caused by the FCC is like an apartment owner suddenly having rent control imposed," says Falcon chairman Marc Nathanson. "It's not just the first rate cut of 10%; it's the second cut of 7% on top of that."

FCC chairman Reed Hundt won't buy that. "Our decision did not make the future of the cable industry more uncertain," Hundt insists. "Our job is to protect the public interest and prevent cable companies from charging monopoly prices." The demise of the Bell Atlantic-TCI deal has certainly not cooled either company's ardor for future consolidations. They are still talking about possible cooperative ventures between them, and each firm is already eyeing prospective new partners. "There's plenty of adrenaline pumping here," Smith says. "We are a company on the prowl." So is TCI. No sooner had the merger collapsed than rumors began flying of a joint expedition by Malone and Barry Diller, who had only just lost his five-month fight for Paramount Communications, to find themselves a Hollywood studio.

If Malone and Smith have taken an exit off the superhighway to the 21st century, both looked more than ready to roar right back on. Most likely, however, they will be driving in separate vehicles.

With reporting by Sam Allis/Boston, Thomas McCarroll and Jane Van Tassel/New York and Jeffrey Ressner/Los Angeles