Building The On Ramp to the Electronic Highway

By Philip Elmer-DeWitt

For years, cable-TV operators and telephone companies have behaved like jealous rivals -- spreading gossip about each other's weaknesses, whining to regulators about monopolistic bullying and watching with suspicion any attempt by one to poach on the other's territory. The sniping has grown even shriller in recent months as it became clear that the two industries were on a collision course in their separate efforts to build the so-called electronic super-highway -- that futuristic information pipeline over which people will soon order up everything from the latest Hollywood movies to the hottest new video games.

So it came as somewhat of a surprise when two of the biggest players -- Time Warner, the nation's second largest cable operator, and U S West, the fifth $ largest telephone company -- announced last week that they were becoming digital partners. In a deal that sent television-, telecommunications- and entertainment-industry analysts scrambling back to their spreadsheets, the two companies announced a $2.5 billion strategic alliance in which U S West will supply technological savvy (and an infusion of badly needed cash) in return for 25.51% of Time Warner Entertainment, one of the world's largest collections of entertainment copyrights, including the film and TV properties of Warner Bros., HBO and Lorimar. (Time Warner's music and publishing operations, which include this magazine, are not part of Time Warner Entertainment and thus are excluded from the deal.)

The marriage of two such powerful partners is certain to accelerate the conversion of modern cable TV into the two-way, interactive system that will allow consumers to order movies, browse through store merchandise, send pictures of the kids to Grandma, make phone calls and request a wide variety of information services -- all by pushing buttons on their TV remote controls. Time Warner officials now say it will take five years -- not 10, as previously estimated -- for these new services to be rolled out to the company's 7.1 million cable subscribers.

The deal is likely to reshape business alliances in both industries. Cable and telephone companies that once viewed themselves as fierce competitors are starting to eye each other as potential mates. "You can bet every major cable operator is talking to every phone company right now," says a cable-industry insider. Meanwhile, the deal could shatter whatever solidarity still exists among the so-called Baby Bells -- the seven regional phone companies that were created by the breakup of AT&T in 1984. Until now, each has enjoyed a monopoly on local telephone service in its own region; long-distance phone companies had to pay a hefty fee to, say, BellSouth, in order to connect to a phone customer in Atlanta. But through its new alliance, U S West will, in theory, be able to provide local phone service to Time Warner cable subscribers outside the Western states, threatening to grab a share of the long-distance connect charges that account for a quarter of the Baby Bells' revenues and half their profits.

What makes the marriage of the two industries so compelling is that each has something the other needs. The TV operators have built extensive networks of coaxial cable with enough information-carrying capacity (or bandwidth) to broadcast hundreds of TV channels simultaneously. The phone companies badly need that cable to replace their narrow copper wires, which can barely carry a single TV station. At the same time, phone companies have sophisticated switching and billing systems that the cable companies would otherwise have to build from scratch.

The rational solution would be to combine both operations into a single system. There's one problem with that: it's illegal. The Cable Act, for example, forbids telephone companies to own more than 5% of a cable-TV programmer in their territory. The cable companies, meanwhile, are not allowed to provide basic telephone services through their coaxial lines.

That's why previous efforts to merge TV and telephone interests have been relatively modest. Earlier this year, Southwestern Bell acquired two cable systems in the metro Washington area -- far outside its operating region. Similarly, Pacific Telesis took an option to buy a cable system in Chicago, although it will need special permission to send cable programming to the system by satellite. Cox Enterprises and Tele-Communications Inc. (TCI), the world's largest cable-TV operator, joined forces last year to buy Teleport, a company that provides a telephone service not covered by the Cable Act: private branch exchanges to business customers.

What made the Time Warner-U S West merger possible was an accident of geography: although U S West covers 14 states and Time Warner has cable franchises in 36 states, there is almost no overlap in the territories they cover. (Even so, the deal had to be crafted to avoid various regulatory pitfalls.) The way the transaction is structured, U S West pays Time Warner $2.5 billion over four years -- $1 billion to upgrade Time Warner's cable systems and the rest to reduce its debt (which had ballooned to $16 billion since the 1989 merger of Time Inc. and Warner Communications). "What's driving this deal is technology, not finances," insists Time Warner chairman Gerald Levin. The key technology, he says, is the digital switch needed to route voice, text and video to each subscriber's home. Time Warner had planned to build the necessary switching system itself but realized about a year ago it needed help. "We underestimated the skills required," says Levin. "I think the cable-TV industry has underestimated the difficulty of entering the telecommunications business."

For its part, U S West has made what some see as a prescient investment in % the movies and TV shows that will be carried over the information highways no matter who owns them. According to W. Russell Neuman, a communications expert at Tufts University, U S West has profited from the lesson Sony learned when it lost the VCR wars a decade earlier. Sony's Beta lost out to VHS because its competitors made better deals with the folks who held the intellectual- property rights -- in this case, the movie companies. That, says Neuman, is why Sony bought CBS Records and Columbia Pictures. It's also why Toshiba and Itochu bought 12.5% of Time Warner Entertainment in 1991.

Although the reaction on Wall Street was largely positive, some analysts focused on the assets Time Warner gave up. If U S West and the Japanese investors exercise all their options, the company could be left with barely more than 50% of the remaining stock in its entertainment division, cutting into the windfall it might otherwise realize should the new medium dramatically increase the value of its movies and TV shows. "The question is whether Time Warner is selling off its crown jewels in little pieces," says David Londoner, an analyst at Wertheim Schroder.

Some consumer groups wondered about the wisdom of putting the distribution system into the hands of the company that controls the information carried over it. "We were told that telephone companies would provide competition to cable companies," complains Jeffrey Chester, director of the Center for Media Education. "Instead of competition, what we are now seeing is the creation of a media supermonopoly."

But officials in the Clinton Administration were briefed on the Time Warner- U S West deal before it was announced, and most observers expect the government to ease restrictions against cross-ownership, not tighten them. "If the law were changed tomorrow," says TCI CEO John Malone,"I believe there would be a wholesale merger of the telephone and cable companies." Some think it has already begun. "The train is leaving the station," says Professor Neuman. "And everybody is scurrying to get on board before it departs."

With reporting by John F. Dickerson and Thomas McCarroll/New York