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AT&T and T-Mobile: Back to the Future

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Many analysts complain, with justification, that the proposed merger of T-Mobile into AT&T would create a duopoly in domestic cell phone service. The combined company would have roughly 42% market share; Verizon, the current leader, would come in second at 32%; Sprint would be a poor third at 17%; other carriers divide up the remaining 9%. (GAO 2009 data)

After three decades of invention, growth, and consolidation, we would be back to 1982. That's when the FCC granted the first commercial license for cellular service to Advanced Mobile Phone Service, Inc. -- a subsidiary of AT&T. The license came with a hard-fought condition: the FCC would license a second carrier in each city.

The cell phone, like so much of the technology we take for granted today, was invented at Bell Labs. A 1947 paper by D. H. Ring (that's really his name!) described the idea of using many low-power transmitters, each serving a relatively small "cell". The cells would be arranged in a hexagonal "honeycomb" pattern. The paper described a hand-off of a call from cell to cell as the caller moved around. It also described how the same frequency could be re-used in different cells, allowing far more calls to be handled.

The concept was far beyond what even Bell Labs could implement in those days of relays and vacuum tubes. It sat on the shelf until the 1960s, when Richard Frenkiel and Joel Engel took up the challenge by applying integrated electronics and computers. President Clinton recognized their work with the National Medal of Technology in 1994.

In 1971, AT&T proposed the first cellular service concept to the FCC. Years of hearings followed. The two-carrier decision emerging along the way to first field trials in 1978 in Chicago and Newark. By 1982, it was ready to go commercial.

The same year, AT&T broke up into seven "Baby Bell" regional operating companies and "Ma Bell": long distance, Bell Labs, and Western Electric. The FCC's earlier decision to require at least two cell phone carriers per city proved prescient. While the Baby Bells lumbered into the cell phone business, literally hundreds of entrepreneurs stormed out of the gate, each building out service in a single city.

A few years earlier, the same thing happened with cable television service. Entrepreneurs wired cities and towns. Then a few entrepreneurs started consolidating local operations into larger and larger regional, and ultimately national, providers. A few, like Comcast in cable and McCaw in wireless, became giants.

At the same time that local systems were consolidating into regional and national systems, both cable television and cellular phone service started to replace their original analog technologies with digital. Digital expanded the capability of both services by factors of 10 to 100 (number of channels for cable, number of calls for cellular), while lowering the cost. Plus, digital meant entirely new kinds of wireless services became possible: text messaging, mobile e-mail, mobile Internet, and so on.

Demand exploded, and in less than a decade, cellular went from relative luxury to everyday necessity. The United States was the first nation to have cell phones, and was the first market to saturate: today 96% of Americans have cell phones.

Market saturation means that carriers have less motivation to innovate to win new customers, because there are few unserved customers left to win. Competition among cellular carriers devolved into a stark battle to retain customers and margins. That's hard enough to do when you have strong differentiation: it's very, very hard when there is little difference in the nature, quality, or price of the service.

Innovation is still very important in a late-stage market. But it's more difficult, because the new product or service must fit into the existing base. Old customers will not abandon everything they are used to even for a very compelling innovation. That is why products like Apple's iPhone and iPad are so hot: they make existing services easier to use and provide a platform for applications that provide new utility on top of existing services.

Thus AT&T was willing to concede so much to Apple to be the exclusive provider of cellular service for iPhones. It may have been a Faustian bargain for AT&T, however. While the iPhone got existing AT&T users to upgrade their service and won customers away from other carriers, iPhone users put far more stress on AT&T's network, driving up their costs. While good for AT&T's top line, it is not entirely clear that it was good for their bottom line.

The cellular industry adopted so-called "friends and family" plans as a way to retain customers (reduce "churn"). These pricing plans offer reduced monthly rates for keeping several phones active with the same carrier. They also eliminate per-minute charges for calls to selected phone numbers, and, more important, to any cell phone served by the same carrier.

The larger the user base of a carrier offering a "friends and family" plan, the better the economics turn out for both the carrier and the customer. The customer benefits from access to more cell phone numbers for which per-minute charges are waived. The carrier benefits from having the contract be "stickier" to more customers: fewer customers are likely to give up the benefits of the family plan by switching to another carrier, thus saving the carrier the marketing costs of acquiring another customer or re-acquiring the same customer. Why is this so important? Because of a dirty little secret of the telecommunications service business: it costs more to market to customers than to handle their calls.

Thus, the T-Mobile acquisition by AT&T could be particularly bad for Sprint. Ironically, Sprint was the first large carrier to offer "friends and family" pricing, starting in their long-distance business.

If Sprint and T-Mobile combined, the resulting carrier would still be third, but a close third (32% Verizon, 30% AT&T, 29% Sprint/T-Mobile). The carriers would be more closely matched on the criterion that could have the most influence on buying decisions: the number of other users your calling plans could access at reduced rates. Three well matched competitors would be better than two giants, a runt, and a crowd of pygmies, some say. Thus, it is conceivable, although perhaps not likely, that the FCC or DOJ will reject the deal out of hand, giving Sprint another shot.

The larger story is that the US cell phone business has matured. It is no longer the wild rush of rapidly advancing technology and raw entrepreneurship in pursuit of new users. To find those conditions, one now has to look to the developing world. And indeed, that's where most of the innovation is happening. But for the US, we could be headed for an effective duopoly of two giant carriers. Back to the future.

The author was a senior officer of AT&T and a member of the Bell Labs Executive Council from 1992 to 1996. He also served on the Board of Directors of Evolving Systems, Inc., a supplier of telecommunications software, from 2005 to 2011.