Anthony J. Pennings, PhD

WRITINGS ON DIGITAL STRATEGIES, ICT ECONOMICS, AND GLOBAL COMMUNICATIONS

The Breakup of AT&T and the Move to Wireless Duopoly, Part II: The Grand Alliance

Posted on | March 21, 2011 | No Comments

The mobile technology industry has been going through a rapid transition, highlighted recently by AT&T’s announcement that it would buyT-Mobile from Deutsche Telekom for US$39 billion to create the largest cellular company in the US. I dug into my notes to explore the formation of this industry which was largely ignored by the AT&T despite initiating some of its early innovations.

Much like J.P. Morgan’s creation of AT&T, the wireless industry was one of the information industries (along with cable TV, fiber optics and satellite TV) largely created through the efforts of financier Michael Milken of the defunct investment firm Drexel Burnham Lambert. Milken helped the McCaw family assemble the wireless industry during the 1980s by raising money to purchase cellular licenses and to buy MCI Wireless for nearly $2 billion. McCaw Cellular Communications was later sold to AT&T Wireless Services in 1994, combining the nation’s largest cellular carrier with the largest long distance telephone company.

The wireless “mobile phone” business emerged about the same time as the breakup of AT&T, which had been under new anti-trust scrutiny since the Department of Justice (DOJ) filed suit in 1974. A year before, Motorola made the first mobile phone call and later in 1977, the FCC gave them permission to build experimental systems in two major cities. In 1980 an AT&T report estimated that the market for mobile phones in the 2000 would be 900,000 subscribers. Consequently when AT&T was forced to break up in 1982, it ceded the wireless business to the local phone companies. It was major strategic mistake that would cost them billions in the future.

Despite the limited market forecast, the FCC felt obliged to assign spectrum to the new mobile service. In May of 1981, they allocated 40 MHz allocated to cellular into two segments in an attempt to create duopolistic competition. One segment would go to the local telephone company in each market and the other would be open to non-telephone companies that wanted it.[1] This way the phone companies could improve the service while the market could be democratized. If more than one company applied for the license, an administrative judge would review the company’s application and judge the merit of its plans and technical capability to provide the service coverage. On June 7, 1982 some 190 applicants applied for FCC licenses to provide cellular in America’s 30 largest cities. The applicants included a wide range of companies looking to make a play in the mobile industry, from the upstart McCaw Company to the former telegraph monolith Western Union. One of the most dramatic technological rollouts of the 20th century was beginning but not without an additional twist in the method.

The year 1984 was a significant one for the development of the technological infrastructure in the US. It saw the introduction of the Apple Macintosh, IBM bought Rolm, a pioneer of digital office technology, and AT&T was divided into the namesake long distance company, a manufacturing entity and an assortment of regional local phone companies. 1984 was also the time the mobile phone industry began a series of dramatic changes. The telephone companies were starting to roll out their cellular services and on April 10th Bell Atlantic made its first cellular call to comedian Bob Hope. Progress also continued for the non-wire companies when in February of 1984, the “Grand Alliance” was born. This was a group of the biggest non-RBOC companies vying for the alternative cellular market. CellNet, Cox Cable LIN, MCI, Metromedia, Metro Mobile, MCI, The Washington Post Company, and Western Union signed a number of agreements to share or merge markets. They also made arrangements for rounds II and III of the FCC spectrum distribution.[2] The reason for the Alliance was the idea of “cumulative chances”. These companies began to agree to merge applications in a given market to increase the chances of one company getting control of a certain area and competing successfully against the local phone company.

In April however the FCC decided to allocate markets 31st to 90th via lottery, even digging up the same Ping-Pong drum used to select draftees during the Vietnam War.[3] Sown into the decision though, were the seeds of its own destruction. The FCC included three rules that ultimately would create chaos and lead to the elevation of McCaw. The government ruled that: 1) applicants could file duplicates of their applications; 2) they would not have to tie up capital; and 3) that the second through tenth place winners would be drawn at the same time. This last decision was made so the lottery would not have to be redone if the first choice became ineligible for some reason.[4] As a result, a new strategy began to form based on the notion of buying “cumulative chances”, and McCaw got the process started.

McCaw was spread quite evenly among cable, cellular and paging but by the summer of 1984 they began aggressively going after cellular. They took a risk and bought Knight-Ridder’s cellular applications for $1 million despite no assurances from the FCC that they wouldn’t declare the previous application ineligible and nix the idea of buying license applications in general. But when Round IV for the 91st to 120th largest markets began, over 5,100 applications arrived. Richard L. Vega and Associates had begun producing applications for $1,500 each whereas applications for Round I had cost about $300,000. The applications flooded the FCC’s headquarters and threw it into disarray. As a result, the FCC announced in late August that it would speed up the process and hold its Round II lottery on October 3. Shocked by the announcement, Telocator, the DC-based trade association for the cellular industry, formed The Counter-Alliance.[5] Within a month, some 150 different businesses representing 700 different applications agreed to merge into 60 partnerships and take the process out of the FCC hands. The Counter-Alliance was headed by McCaw aide John Stanton. Stanton skillfully brought together the smallest of the FCC applicants with the promise of working out their differences and combining their “cumulative chances” into controlling interests.

What would transpire in a New York City conference room is probably the most unheralded major telecommunications event of the 20th century. The Counter-Alliance put the smaller players back in the game but it also allowed McCaw to develop relationships that proved useful later for acquisitions. With Stanton reaching out to small license holders across the nation, McCaw was doing valuable research for future acquisitions. But that future was still unclear. In September a “trading room” was formed at Rubin Baum law offices in NYC to work out what was called “Le Grand Deal”.[6] Representatives from Rounds II and III met in a conference room on Fifth Avenue to trade license applications in order to increase the chances that a company could control a single market, say Austin, Texas. Since the lottery would be drawn for the first 10 applications, the idea was that a single company could trade licenses in other markets in order to increase their chances to control other markets.

One crucial issue was equivalence. What would be the metric of value? How would the traders determine the value of each market. Their answer was the “POP”, a value determined by the 1980 population census. The traders worked out a formula that divided the population of an area by the number of license applicants. For example, Orlando Florida had a population of 700,000 people. Thirteen companies had applied for the FCC license in that area. So each application was allocated 55,000 POPs. A value of $3 per POP was used based on the McCaw-Knight-Ridder deal. Each could trade POPs for POPs.

In January of 1985, Pacific Telesis, a West Coast RBOC, announced that it wanted to expand its cellphone business. Its target was CellNet’s interest in a San Francisco license. A month later McCaw asked the FCC to block Pacific Telesis on the grounds that the big RBOCs had no incentive to provide good cellular service since it would compete with its land services. It also filed suit in the California Supreme Court to block Pacific Telesis purchase. The lawsuit caused widespread uncertainty about the wireless industry. One of the first big companies to abandon the cellular industry was MCI. After losing the Los Angeles license and consequently setting back its plan for a national network, MCI decided that it wanted to sell its cellular interests. McCaw would lose the lawsuit the next year, but the attempt would keep a number of nonwireless companies out of the wireless business and in the meantime the uncertainty would keep POP prices cheap.

MCI shunned a McCaw deal at first, thinking they would not have the money. In August MCI nearly completed a deal with American Cellular Communications Corporation (ACCC) but after discovering the company was heavily financed by BellSouth, it ended the negotiations. McCaw was back in, and soon inked a deal with MCI, but it needed major financing. In the Fall of 1985, McCaw took a health sabbatical while the company searched for capital to complete the MCI deal.

McCaw needed some $225 million to buy parts of MCI’s wireless and paging businesses and gain a stronghold in the cellular business. In the spring of 1986, Salomon Brothers approached McCaw with the promise to provide funding but came up painfully short as the MCI deadline approached. After several months of prefatory research, the famed Wall Street financial operator could only raise $4.5 million.[7] The McCaw executives were beginning to worry that MCI might back out if they failed to deliver payment in time. With POP prices were rising again, McCaw needed to secure the deal with MCI and pursue other acquisitions as well. Desperate for the needed capital, McCaw executives visited Michael Milken.

The visit to Drexel is famous for Milken’s opening statement, “You guys needed brain surgery and went to a bunch of veterinarians.”[8] But the king of junk bonds was prepared. He then proceeded to recount for the McCaw executives (Craig McCaw was on a health sabbatical) who Salomon Brothers had approached for funding and why they were not successful. He then asked how much they needed. To their reply of $225 million, he responded, “The first thing we need to do is increase the size of the deal. We’ll go for $250 million.”[9] Hearing of the Milken meeting, Craig McCaw endorsed the new direction wholeheartedly, preferring to take on the debt load rather than giving up control and equity in a joint venture. But the funding had to be in place before the July 3rd deadline, just weeks away. Otherwise, MCI could renegotiate the price, or worse, change their minds.

The summer of 1986 was a dynamic one for the wireless industry. Emboldened by the potential Drexel funding, the McCaw team launched a campaign to dramatically expand their cellular holdings, including buying 9 million POPs throughout the Southern states in cities like Jacksonville and Memphis. Just days before Drexel bond closing, Southwestern Bell and Metromedia announced a deal at $45 a POP, two and half times more than McCaw’s current deals. If Milken could not deliver, and the MCI deal went into default, McGowan and company would certainly restructure the deal beyond McCaw’s financial capabilities. On the crucial day, McCaw executives went to MCI headquarters with Milken’s assurance that the bond sale had closed successfully the day before. But they still needed to deliver the money, an act that depended on multiple electronic wire transfers. As 3 P.M. approached, still no word from the MCI treasurer. Then at 3:25 PM, the word came, the money had arrived, and the deal had closed.

McCaw was soon propelled into the number one cellular company in the US. With the Drexel war chest, the McCaw team scoured the countries for deals. Returning from sabbatical in September 1986, McCaw put the cable business up for sale and began to focus exclusively on cellular. Taking advantage of their experience with the Counter-Alliance and Big Monopoly Game, they contacted the licensees they had been working with. “By the summer of 1987, just before the IPO, McCaw owned licenses covering 35 million POPs in 94 markets—nearly twice as many POPs as the second biggest nonwireless company, LIN Broadcasting, which had 18 million.”[10]

When McCaw went public later in 1987, the decision to use junk bonds was figured to have saved the owners nearly $1.2 billion. By going with debt instead of dispersing equity, not only did the McCaws retain their ownership, but also their control, flexibility, and independence. Drexel raised nearly $2 billion for McCaw Wireless, and in return made approximately $45 million for itself.[11] McCaw was bought by AT&T in September 1994 and the McCaw family wound up as ATT’s biggest owners with over $2 billion in the company’s stock.[12] Craig McCaw and his brothers amassed a fortune of $6.4 billion by the summer of 1998.[13]

Notes

[1] While AT&T was the dominant phone company, GTE had a significant share and small companies such as the Warwick Phone Company in Warwick, New York also provided service.
[2] Alliance formation from James B. Murray, Jr. (2000) Wireless Nation: The Frenzied Launch of the Cellular Revolution in America. Cambridge, MA: Perseus Publishing. p. 77.
[3] Sale of McCaw Cable from James B. Murray, Jr. (2000) Wireless Nation: The Frenzied Launch of the Cellular Revolution in America. Cambridge, MA: Perseus Publishing. pp. 146-147.
[4] FCC three rules from James B. Murray, Jr. (2000) Wireless Nation: The Frenzied Launch of the Cellular Revolution in America. Cambridge, MA: Perseus Publishing. pp. 81-82.
[5] Counter Alliance from James B. Murray, Jr. (2000) Wireless Nation: The Frenzied Launch of the Cellular Revolution in America. Cambridge, MA: Perseus Publishing. p. 92.
[6] from James B. Murray, Jr. (2000) Wireless Nation: The Frenzied Launch of the Cellular Revolution in America. Cambridge, MA: Perseus Publishing. p. 92.
[7] McCaw choice of Drexel over Salomon Brothers from O. Casey Corr’s (2000) Money from Thin Air. p. 138. The figure of how much Salomon Brothers raised has been quoted as long as $2 million by James B. Murray, Jr. (2000) Wireless Nation: The Frenzied Launch of the Cellular Revolution in America. Cambridge, MA: Perseus Publishing. p.200.
[8] Brain surgery quote from James B. Murray, Jr. (2000) Wireless Nation: The Frenzied Launch of the Cellular Revolution in America. Cambridge, MA: Perseus Publishing. p.201.
[9] $250 million quote from James B. Murray, Jr. (2000) Wireless Nation: The Frenzied Launch of the Cellular Revolution in America. Cambridge, MA: Perseus Publishing. p.201.
[10] 35 million POPs quote from James B. Murray, Jr. (2000) Wireless Nation: The Frenzied Launch of the Cellular Revolution in America. Cambridge, MA: Perseus Publishing. p.205.
[11] McCaw raising of money at Drexel from O. Casey Corr’s (2000) Money from Thin Air. p. 140.
[12] McCaw ownership of ATT from O. Casey Corr’s (2000) Money from Thin Air. p. 226.
[13] McCaw fortune from FORBES.COM, “Craig McCaw – The Wireless Wizard of Oz”. 6/22/98. Accessed on February 12, 2004. Figures are for 1998 when the prices of stocks were quite high.

Anthony

Anthony J. Pennings, PhD has been on the NYU faculty since 2001 teaching digital media, information systems management, and global communications.

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    Professor and Associate Chair at State University of New York (SUNY) Korea. Recently taught at Hannam University in Daejeon, South Korea. Moved to Austin, Texas in August 2012 to join the Digital Media Management program at St. Edwards University. Spent the previous decade on the faculty at New York University teaching and researching information systems, media economics, and strategic communications.

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