Forecaster Cleland Skeptical About AT&T-TCI

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Scott C. Cleland is the Washington, D.C.-based managing
director of the Precursor Group of Legg Mason Wood Walker Inc. His job is to forecast
trends in cable and phone markets -- not to pick stocks for investors. Cable leaders in
Washington seek his counsel, and chairmen of congressional committees request his
testimony. In an interview with
Multichannel News Washington editor Ted Hearn,
Cleland said he's pessimistic that AT&T Corp. can profitably transform
Tele-Communications Inc. into a competitor to the local phone providers. Cleland talked
about the AT&T-TCI deal and other cable and telephony issues. An edited transcript
follows:

MCN: You're not an optimist about the deal between
AT&T and TCI. Why?

Cleland: This is the fourth attempt in four years to
mate a telco with a cable company. Bell Atlantic [Corp.], U S West [Inc.] and Sprint
[Corp.] have all tried it and pulled back, and they didn't believe that it could work
as a business model.

So the big question is: What does AT&T know that
Sprint, Bell Atlantic and U S West don't know?

MCN: Isn't the theory here that AT&T has decided
to buy instead of rent -- meaning that the money that it spends to upgrade TCI's
systems to deliver voice services will come back to it in the form of reduced access
charges paid to incumbent phone companies?

Cleland: That's one of the great appeals, to be
able to bypass access charges. However, to make that model work, you have to have
comparable lifeline service. And that's the rub.

MCN: Do you think that AT&T can transform TCI's
cable systems so that they are equal in quality and reliability to the networks of
incumbent telcos?

Cleland: I am highly, highly skeptical that they will
be able to do it at a comparable quality level to telcos today in a profitable way.

MCN: What does that say in terms of your opinion of
AT&T's senior management? Are you saying that they failed to do proper due
diligence?

Cleland: It is more instructive about the bad options
facing AT&T. This may be the best available of rotten options. Their resale isn't
working; their fixed wireless is way behind schedule, and it probably won't work as
planned for a long while; they can't buy a Bell; and investing in facilities on their
own is too costly and takes too long. So the cable option may be the only option available
of rotten options.

MCN: What about the fall in AT&T's stock? Could
that buckle the knees of investors in both AT&T and TCI and scuttle the deal?

Cleland: There is some risk that the deal won't
survive. But if it doesn't, AT&T owes almost $2 billion to TCI in a breakup fee.

MCN: Do you think that the AT&T-TCI merger will be
approved?

Cleland: This doesn't have regulatory problems.
This is going in the direction that regulators wanted the Telecommunications Act of 1996
to go. This is not an antitrust problem because it's two independent industries
coming together.

MCN: Let's switch to cable regulation. Do you think
that Congress will extend cable regulation beyond March 31, 1999, or perhaps do something
later in 1999?

Cleland: I don't think that the sunset date is
going to be delayed. There's going to be a lot of jawboning going on, but we're
in a very different political situation than we were in 1992. For example, the economy is
screaming; at that time, it was in recession. The Congress was Democratic in the past;
now, it's Republican. I just don't see it occurring before the sunset date.

MCN: And I suppose that's your opinion about the
rate-freeze legislation, too?

Cleland: Yes. I think that your rate-freeze legislation
is unlikely to pass. It'll be talked about, it'll be used to jawbone and
it'll be used as moral suasion to try to get the cable companies to behave.

MCN: Do you think that there will be any bolt-tightening by
the Federal Communications Commission?

Cleland: That's probably not likely, because in a
sense, the FCC would be going against the grain. Congress has said in the law that they
wanted to move toward deregulation, so in this last year, it would be unlikely for the FCC
to go in the opposite direction.

MCN: Rep. Ed Markey (D-Mass.) predicted that cable
operators will go hog-wild once they're deregulated. What's your assessment of
the ability of direct-broadcast satellite to check cable rates and prove Markey wrong?

Cleland: I think that some rates are going to increase,
but unless the cable operators get collective amnesia, they're not going to go
hog-wild. While cable's political situation is dramatically improved over the
situation in 1992, the cable industry collectively knows that it is still on very thin ice
in Washington.

MCN: Markey said continued cable regulation is necessary
because the Baby Bells, except for Ameritech Corp., reneged on their promise to carpet
cable markets with their own video networks. Why have the phone companies generally failed
to compete against cable operators, after going all the way to the Supreme Court to have
the cable-telco cross-ownership ban lifted?

Cleland: Well, there's two reasons. One, the
cable-telco ability to cross-compete technologically has been questioned. The cable
industry has had a lot of difficulty getting into the telephone business.

And the second reason is that Congress killed cable-telco
competition in the [Telecommunications Act of 1996]. They didn't realize that they
were doing it. But the cable industry very cleverly and very capably got the
open-video-system language written in such a way that it was largely prohibitive for
telcos to use that method to get into the cable business.

And how did that occur? How did the Bells allow it to
occur, since they're so powerful on the Hill? Frankly, they had bigger irons in the
fire. They had bigger fights. And this is one where they let it go because it was one of
the largest fights for the cable industry.

In essence, what the open-video-systems language does is
make it too expensive for a telco to pursue that path. They have to build a system three
times larger than they would want to in order to reserve two-thirds of the space for a
competitor if they came along and wanted to use it.

MCN: Your point there is that the two-thirds set-aside is
statutory, and the FCC, in your view, couldn't have been in a position to waive a lot
of regulations that the telcos didn't like, and that they said were barriers to their
entry?

Cleland: Yes. Actually, the open-video-systems statute
is an effective barrier to entry. Congress set the bar too high. And we can all sit around
and say, 'Well, they should have two-thirds of their channel space open,' but
unless the telcos believe that, they're not going to build it. And I think that their
view is that Congress set too high a price.

MCN: Why is Ameritech building traditional cable systems?
Why aren't all of the telcos aping the regulatory model that cable operators fall
under?

Cleland: Ameritech was trying to make a go of it, and
it found that in some communities, there was an appetite for people who were upset with
their cable company to switch over. But as a national model, it's been very expensive
to have an overbuild, a terrestrial overbuild.

MCN: Do you think that SBC Communications Inc. will sell
off or somehow terminate Ameritech's participation in cable, if their merger goes
through?

Cleland: My gut guess is that SBC will not ramp up
Ameritech's cable operation; it would either stand alone, or SBC would scale it back.

MCN: Some in Congress -- Rep. Billy Tauzin (R-La.), for one
-- are searching for ways to promote cable competition other than through rate controls.
Have you had a chance to evaluate Tauzin's proposals, which would seem to require the
establishment, say, of a sports-programming tier, and the creation of smaller cable
packages?

Cleland: There are very few people on Capitol Hill as
clever as [Telecommunications Subcommittee] chairman Tauzin, and I think that this is a
very clever political proposal because it is structured on choice, and every politician
wants to provide choice to their consumers. So it may be technically difficult, and the
cable industry may not like it one bit. It certainly has an enormous amount of political
appeal, and it's a very shrewd threat from Capitol Hill.

MCN: What do you think the chances are of structural reform
passing this year or in 1999?

Cleland: I don't think that there's going to
be any structural reform of the cable industry or the Cable Act this year. I think
it's very, very slim.

Next year, there will be a more significant chance, but I
still don't think that there will be a significant cable regulation in 1999, although
people should look for the DBS local-to-local issue to surface in 1999, because of the
need to reauthorize the [Satellite] Home Viewer Act.

MCN: Senate Commerce Committee sources are talking about a
legislative idea to require cable operators to offer a broadcast-basic tier that would be
price-capped at, say, $5 or $6 per month. The operator would have the option of including
traditional satellite programming in that tier, but it couldn't recover the cost of
that programming. What do you think of an idea like that? Do you see that as being as
clever as Tauzin's proposal?

Cleland: I don't know if it's as clever as
the other proposal, but it certainly has smart politics behind it.

MCN: Another idea contained in House-Senate legislation is
to allow DBS companies to bundle local-broadcast signals with satellite programming. How
crucial do you think the local-into-local option is to DBS' future?

Cleland: If you're talking about head-to-head
competition with the cable industry, over 60 million households, local-into-local is
important. It's not important to all users; obviously, we have roughly 9 million DBS
customers right now. But it is important for the mass audience.

MCN: Do you agree with the cable industry and broadcasters
that to the extent DBS companies offer local-broadcast signals, there should be a
must-carry mandate?

Cleland: In the short term, with existing technology,
must-carry for DBS is an anchor around its neck. It's a clever, friendly kiss of
death. If you're trying to carry every local channel, I think that you need a lot
bigger satellites than what they have right now.

MCN: Still another idea is to deny exclusivity to cable
programming that is owned by entities other than cable operators and distributed by means
other than satellite.

Cleland: If Congress gets into a lot of these issues
next year, with local-into-local and program access, there's a lot of mischief that
can be done. In the past, Congress has given DBS nondiscriminatory access to cable
programming, which the cable industry feels is outrageous, but it's the law of the
land. So there clearly is a lot of room for mischief, and people should keep an eye on it.

MCN: Do you accept the view that had there not been
program-access laws, there would be no vibrant DBS industry today?

Cleland: Not as vibrant as it is today.

MCN: I'd like you to look into your crystal ball.
Who's going to win the race to be the dominant provider of high-speed Internet
access: cable modems, telcos with asymmetrical digital subscriber line, or something else?

Cleland: It's not going to be one or the other.
There are going to be many methods into the home, but my view is that the overwhelming
majority, long-term, will be through the telco copper wire.

It's ubiquitous. The cable industry only covers
two-thirds. The architecture is more robust. And frankly, I think that people don't
necessarily need blazing speed to the Internet. They just need good speed, solid speed.
And on a broad scale, reaching tens of millions of American households, the telcos will
have the finances and the plant that will make them the dominant provider, long-haul.

MCN: So are you saying that cable is offering a Ferrari
that's not going to be a winner in the mass-market?

Cleland: I think that cable is offering a Ferrari
service, but do all of us need Ferrari speeds? The mass-market probably needs the Ford
Taurus capability, which is fast enough to get there, but they're not necessarily as
willing or as interested in paying a super premium to get the Ferrari-like speeds.

MCN: You've argued that local phone competition today
is really ersatz competition, and that new entrants are cream-skimming business revenue
from incumbents that was meant to subsidize residential service where there's little
competition. If you're right, how long can that go on before something snaps, leading
to higher residential rates?

Cleland: That's one of the big political dilemmas
for the regulators and the politicians. They've unleashed a policy that they
didn't think through politically.

Politically, I don't think that there's but a
handful of members of Congress that want local rates to go up. The overwhelming majority
-- probably 500 out of 535 legislators -- don't want local rates to go up or rates to
be rebalanced. They like it the way that it is, because right now, it's as good as it
gets. People get their local phone service for roughly 50 percent below cost. And how
that's paid for is a labyrinth of subterranean subsidies -- long-distance access
charges, high business rates to subsidize residential rates, and urban users subsidizing
rural users -- and then vertical services being priced too high, like caller ID and voice
mail.

MCN: Isn't the system going to break down? Where is
the money going to be to keep residential rates affordable if the traditional funding for
that is going into the pockets of private companies that are targeting business customers?

Cleland: Politicians and regulators are good at one
thing, and that is taping and Band-Aiding and strapping something together to make sure
that it doesn't blow up. So we're in a mode of patch-up policy because the
Telecom Act, in this aspect, is in a whole lot of trouble.

MCN: I bounced your local-phone-competition analysis --
which really accords with recent speeches by Ameritech chairman Richard Notebaert -- off a
lawyer who represents competitive local-exchange companies, and he said your analysis was
flawed. He said there would be more residential phone competition in the future if the
states got on the stick and created universal-service pools from which new entrants could
draw support. What's your response?

Cleland: What the person is saying is that if the
regulators would subsidize residential competition like they've subsidized business
competition, there would be tons of competition. I use the example of competition -- it is
a lot like growing agriculture in a desert. Saudi Arabia has shown us that if you are
willing to subsidize the amount of water, you can grow anything in a desert. You can grow
competition in any market if you're willing to subsidize the competitors.

And the situation that we have right now is that regulators
in business markets have set prices twice as high as they would normally be in order to
keep residential rates low. Now, if a competitor can't compete where there is an
artificially high price -- twice above what it should be -- then there's something
wrong.

MCN: Do you believe that there will not be robust
residential phone competition until residential phone rates are allowed to rise to
cost-based levels?

Cleland: There are a couple of questions there.
Allowing residential rates to rise to cost-based levels is politically very, very
difficult, and I'm one who believes that the Telecom Act got it wrong in that they
thought that these markets were going to be very competitive.

In the residential market, cable telephony hasn't
shown up. Fixed wireless hasn't shown up in any large scale, and it's probably
going to be at least five years before they do. So we will see spot competition in a few
places, but if you're talking about competition like Congress envisioned it, with
tens of millions of households having a choice of their local phone provider, it's
not going to happen for at least five years, and probably longer.

MCN: If your critics are right about state regulatory
disincentives, are you still of a view that cable entry into telephony has been, as you
told the Senate recently, "an abysmal failure, and it will be a long, long wait
before millions of American consumers will enjoy a competitive telephony alternative from
cable?"

Cleland: It is going to be a long time. The main
problem with cable telephony is the architecture getting the reliability and robustness
that copper technology has. The copper technology has been perfected over 60 years to be
near perfect in delivering dialtone and lifeline services to residences. People are not
willing to give up 911 reliability. That's the crux of the issue: When will cable be
as reliable as the existing telephone system?

MCN: Does mandatory cable carriage of digital-TV signals
mean life or death for the transition from analog to digital, as some seem to believe?

Cleland: Digital TV has been a really difficult issue.
A lot of digital TV is an idea in search of a business model. So this part of one's
crystal ball is very unclear, because the future of digital TV and high-definition digital
TV is unclear.

There are more than 220 million TV sets out there, and
it's an enormous amount of consumer cost to replace them in order to receive the new
signals. So I think that this transition is going to be one of fits and starts. It could
take longer than people anticipate, and the mandatory carriage is going to be an issue
that'll be fought over for a while.

MCN: Do you think that the technical arguments over display
formats that cable is throwing at the FCC are going to prevail, or do you expect the
broadcasters to use their muscle to secure some kind of mandatory carriage of digital-TV
signals?

Cleland: That's a tough one -- probably too close
to call. Generally, on these issues, a tie goes to the broadcasters.

MCN: To what extent do you see the FCC relaxing
media-ownership rules? For example, the cable-system/TV-station cross-ownership ban in the
same market. Should a rule like this be relaxed or repealed?

Cleland: I know that the industry clearly would like
these to be relaxed and repealed in the spirit of the 1996 Act, which dramatically
loosened the ownership rules on radio and on TV. However, I think that the Clinton
administration and the FCC, which has three Clinton Democratic appointees, will be slow to
continue the relaxation of media ownership.

Something may pop out, but it'll be the exception,
rather than the rule. In general, the Clinton administration thinks that consolidation in
this media industry has gone way too far, and they're unlikely to douse gas on the
fire.

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