ENEMY AT THE GATES: CABLE NEMESIS

AOL Time Warner wants to become the dominant cable power in the country. AT&T Broadband is on the table. Microsoft is willing to pay big bucks to prevent a merger.

Microsoft has placed a bounty on AOL Time Warner. As a bidding war has erupted for AT&T's cable unit and Excite@Home has crumbled, the last thing Microsoft wants to see rising from the dust is a combined AT&T Broadband/AOL Time Warner.

The reason is simple: The merger would create a cable and content empire with the world's largest consumer broadband network. AOL Time Warner could use it to shut out MSN from nearly 27 million broadband homes. Microsoft is determined to prevent that scenario by any means — including paying cable competitors to foil AOL Time Warner's plans.

The battle rehashes an old grudge match between Bill Gates and Steve Case — chairmen of Microsoft and AOL Time Warner, respectively — for dominance over PC desktops. But this spat could drastically reshape the cable industry, which has already endured one of its most tumultuous periods.

Last week, AT&T Broadband emerged as the hottest commodity in the country after single-handedly squashing cable broadband provider Excite@Home in a risky game of chicken. In the ensuing fallout, 850,000 customers saw their cable modem connections severed, angry consumer groups called for cable regulation, DSL carriers swooped in to scavenge subscribers, and the once-mighty @Home officially toppled as AT&T yanked its bid for the carrier's networks.

 

FactBox: AOL Time Warner Steve Case and Richard Parsons Cable subscribers: 12.7 million Cable modem subscribers: 1.7 million Total homes passed for cable services: 21 million Homes passed with cable modem service: 96%

That same day, news agencies revealed two new challengers to Comcast's $58 billion bid for AT&T's cable unit: AOL Time Warner and Cox Communications. Microsoft emerged as either a potential dealmaker or dealbreaker, agreeing to put its financial weight behind either Cox or Comcast's bid. Reportedly, the software giant even offered to support AT&T, if it decided to spin off the unit — all in an effort to thwart AOL's bid.

The challenge is finding out how much is at stake, said Keith Kennebeck, analyst for the The Strategis Group. “Microsoft doesn't know what AOL's bid is, and it has to be sure it's ready to match whatever AOL is offering,” he said.

Officially, Comcast is the only confirmed bidder, and few details of the bids have been reported. A Microsoft spokeswoman dismissed the reports as speculation, but most industry experts have little doubt that the reported bidders want to buy AT&T Broadband.

FactBox: AT&T BROADBAND C. Michael Armstrong Cable subscribers: 13.7 million Cable modem subscribers: 1.4 million Total homes passed for cable service: 24.6 million Homes passed with cable modem: 74%

AOL Time Warner's bid carries the biggest consequence for the cable industry and Microsoft if successful. Combining AT&T and AOL's cable operations would create a multiple systems operator of 26.4 million subscribers — more than three times its nearest competitor. The company would control more than 38% of the market.

Given the programming and content holdings of AOL and Time Warner Entertainment, such a deal would match any media merger in history and give the company leverage in any cable industry deal, said Ryan Jones, analyst for The Yankee Group.

“Time Warner and AT&T would make an unnervingly large cable operator with both the pipe and media to change the way consumers intake entertainment,” Jones said.

AOL could pit itself directly against Microsoft, denying MSN access to more than a third of the country's cable modem lines and crippling Microsoft's Interactive TV plans. Furthermore, AOL would try to shut Microsoft products out of its networks, escalating the two companies' long-standing feud over browsing, instant messaging and multimedia applications, Kennebeck said.

FactBox: MICROSOFT Bill Gates Cable subscribers: 0 Cable modem subscribers: 0 Total homes passed for cable service: 0 Homes passed with cable modem service: 0

But the same advantages don't apply to Microsoft if Cox or Comcast won with its help. Microsoft's motives are purely defensive, analysts said. Instead of controlling a cable empire, Microsoft would be an investor in the country's largest MSO, rivaling AOL Time Warner but not dwarfing the entire industry as a merged AOL/AT&T Broadband would.

Microsoft can take some comfort in knowing an AOL/AT&T deal would face intense regulatory scrutiny. When Comcast started bidding for AT&T Broadband in June, most analysts dismissed AOL Time Warner as a possible bidder because the FCC would not let the two leading cable players combine.

Since then, the corporate-friendly attitudes of the FCC and Bush administration have become apparent, making the successful creation of a cable megacarrier much more likely, said Cynthia Brumfield, president of Broadband Intelligence.

FactBox: COX COMMUNICATIONS James Robbins Cable subscribers: 6.2 million Cable modem subscribers: 779,000 Total homes passed for cable service: 9.9 million Homes passed with cable modem service: 8.7 million

With the former 30% market cap all but abandoned, the real test may be how the government handles the proposed EchoStar and DirecTV merger. The creation of a satellite monopoly would pave the way for the creation of a dominant player in another broadband technology.

Still, Brumfield warned a buyout the size and scope of AT&T Broadband won't be a cakewalk for AOL. “Somebody will squawk somewhere,” Brumfield said. “There will be huge regulatory issues to overcome, but this may be the best time to try to overcome them.”

Another wild card may the relationship between AT&T and AOL Time Warner, which has grown contentious as AT&T has tried to sell its 25% stake in Time Warner Entertainment to the media giant. Because the stake lacks voting power, AOL Time Warner is the only interested party and has been lowballing its offers, according to AT&T.

FactBox: COMCAST Ralph Roberts and Brian Roberts Cable subscribers: 8.4 million Cable modem subscribers: 2.1 million Total homes passed for cable service: 13.9 million Homes passed with cable modem service: 9.6 million Sources: AOL Time Warner, AT&T Broadband, Stratecast Partners, Cox, Comcast

Facing the regulatory and public relations hassle of acquiring AT&T's cable unit, AOL may opt to grab its Time Warner Entertainment stake and run, but most analysts believe AOL is serious about acquiring AT&T's assets. AOL Time Warner's appointment of cable guru Richard Parsons to replace outgoing CEO Jerry Levin is a sign that AOL is thinking seriously about expanding its cable operations, Brumfield said.

Analysts described AT&T's handling of the bidding process as “schizophrenic.” While instigating a bidding war to drive up the price of its broadband assets, Chairman and CEO C. Michael Armstrong has maintained AT&T wants to spin off the unit.

“This could be a long drawn out process,” said Patrick Comack, telecom analyst for Guzman & Co. “When they announce a winner at the end of December, it's not going to end.

---

With reporting by Amalia D. Parthenios, Glenn Bischoff and Donny Jackson.