(FORTUNE Magazine) – REMEMBER not so long ago when no one had a personal computer, and roller skates had metal wheels, and there was only one telephone company and everybody hated it? Simpler times, simpler feelings. Today, ten years after the death of Ma Bell, telecommunications is in a stormy evolution toward digital technology that will transform the way phone companies compete, and affect your every call, fax, computer transmission, paging message -- and phone bill. | Digital technology will make the phones we use today seem like two cans joined by a string. Within perhaps four years, we will see cellular service that costs almost as little to use as the corner phone booth, hand-held communicators that will let us scribble notes with an electronic stylus and zap them wirelessly anywhere on earth, and networks that will automatically deliver our calls to the people we want to reach, wherever they happen to be. Travelers will commune with the office network as fully and easily as if they were sitting at their desks; workers with computers will commingle video, voice, data, and images on a single line as they seamlessly collaborate with faraway colleagues. For phone companies, digital technology can be as potent and vivifying as a wonder drug. It enables them to jump into new businesses and roll out new services with unprecedented ease and speed. By converting conversations and other content into the ones and zeros of computer language, phone companies can store, send, and manipulate them cheaply and efficiently. With the help of ever more powerful computer workstations, the companies can break the software programs that run their giant networks into small, manageable segments and make changes to these segments themselves. A few years ago, if a Baby Bell wanted to introduce a service like Caller ID, which lets you know who's calling before you answer the phone, it would have had to modify the million- line master program that runs its telephone switches. That would have meant going to the manufacturer, AT&T, and waiting five years for the painstaking job to be done. Now a Baby Bell can sometimes introduce a new service in a matter of weeks. With such zippy sophistication at hand, you'd think the industry would be all sheets to the wind. Instead, the main players seem caught in a Sargasso Sea of contentiousness and regulatory inertia. Just try to discern the pattern in these events since mid-June: The Baby Bells sued for the right to enter the long-distance business; the House of Representatives voted for the first major revision of communications law in 60 years; regulators told a phone company it could offer cable TV on its home turf; a cable TV company signed a deal to offer local phone service; competing alliances of Baby Bells announced plans to merge their cellular businesses; the government completed its first-ever auction of the public airwaves, taking in twice as much money as expected, with a bigger auction to come at the end of the year. % Got that, or does it make you want to hang up and try again later? The telecommunications industry, by some measures bigger and more lucrative than the computer business, is both intricately interwoven and heavily regulated, which can make understanding it a real chore. Where does a company like Bell Atlantic get the nerve to bring a lawsuit claiming that AT&T's purchase of McCaw Cellular Communications is anticompetitive, only a few weeks after merging its own cellular operation with that of Nynex -- the better to compete with AT&T and McCaw? How can the long-distance suppliers AT&T, MCI, and Sprint, with equal self-righteousness, complain to Congress that the Baby Bells are impregnable monopolies -- even as they bypass the Bells to skim off lucrative local traffic from business customers? The posturing reflects the huge sums at stake and the vast resources of the players. The phone companies are financial jumbos with entrenched businesses and few competitors. Yet the local and long-distance companies face disparate futures. The Baby Bells, which are still regulated monopolies, had total revenues of about $84 billion last year, with operating income of $17 billion. About a quarter of the sales and a third of the profits come from "access charges" that long-distance companies must pay the Baby Bells for relaying calls to local customers. Another $10 billion in sales comes from toll calls, typically between cities and their suburbs. Such calls are high-margin items: They cost about the same to deliver as a local call, yet regulators allow the Baby Bells to charge about five times as much.

BUT GROWTH in the Baby Bells' local markets is snail-like -- revenues are up less than 10% over the past four years. And with long-distance companies increasingly bypassing the Baby Bells and running lines directly to office buildings, the take from access charges is sinking. No wonder the Baby Bells are eager to shed regulatory restraints and compete in a wide-open market. The long-distance industry, which is slightly smaller in annual sales, is a racier money machine. True, AT&T does have to contend with a pair of archrivals in MCI and Sprint, but oligopoly is still pretty good business. And Americans are a gabby lot: This year they will make about 500 billion minutes of long-distance calls and fax transmissions. The business is expanding faster than that of the Baby Bells, up 20% over the past four years. Operating margins, though slimmer than the margins of the Baby Bells, are growing fast. That's partly because, despite their heavily hyped savings plans for consumers, long-distance companies have actually been raising prices. AT&T, for example, offset costs of its True discount program with $1.5 billion in rate hikes for us saps who are too dumb to sign up. So long-distance companies are happier with the status quo. Enter digital technology, which enhances the fractiousness since it lets companies do more things more quickly. And with the stakes so high, more of them want to. The Baby Bells are desperately trying to get into the long- distance business through legislative and legal maneuvers, but the process is tedious; they're also rushing onto the fertile, open ground of wireless technology. Meanwhile, telephone and cable-TV companies are struggling to cross into each other's territories. Now the first small openings to freer markets in telecommunications are beginning to appear.

-- CONGRESS GETS INTO THE ACT. If technological progress seems to have caused no change in the relations between the Baby Bells and AT&T since Ma Bell broke up in 1984, that may be because the higher authority to which they answer comes from another era. Until this year, Congress hadn't set its pen to a major telecommunications bill since stockbrokers were selling apples for a nickel. Under consideration on Capitol Hill is a new law whose stated aim is to remove barriers to competition while safeguarding the public interest in cheap, universal phone service. These are noble goals that no one questions -- not in public, anyway. For the bill is really a contest between AT&T and its offspring about who gets set free first, and the combatants are about as motivated by the public good as the Spanish conquistadors. Though each side knows that eventually it will be able to enter the other's business, neither is ready to endorse a simultaneous assault. Former AT&T chairman Charles Brown, who oversaw the breakup, observes bemusedly, "It's funny how so many of the actors in this drama talk about the same goal but are pulling in different directions." The Baby Bells claim that for them, competition has already arrived. Forget that they and GTE (the largest local phone company and not a Baby Bell) control 90% of the phone lines in the United States: Bypass companies such as Teleport Communications Group and MFS are stealing business customers by running fiber directly from office buildings to the nearest switch of a long- . distance company, which has sapped Baby Bell business revenue by as much as 20%. So, tit for tat, the Baby Bells want to get into the long-distance market right away. At the same time, they'd like to keep their monopoly on toll calls between cities and suburbs. Physically, it's easier for the Baby Bells to enter long distance than for long-distance companies to invade the neighborhoods. That's because long- distance installations account for only 5% of the mileage in the nation's phone system, while the wires in neighborhoods account for 75%. It would cost too much for long-distance companies to run all their own wire to customers' houses and offices, so to compete in local markets, they'll have to rent most of their capacity from -- you guessed it -- Baby Bells. Working out a way of doing this so newcomers aren't put at a fatal disadvantage is the crux of the legislation and the cause of much wrangling. The lobbying has been most intense in the upper chamber, where Senator Ernest Hollings of South Carolina sponsored a bill that had the Baby Bells mewling. It would have delayed their entry into long distance until they could prove that they faced "actual and demonstrable" competition. This would entail satisfying myriad conditions, such as arranging for customers to keep the same phone number when switching to a different local company -- a particularly tough nut technologically, despite the arrival of the digital age. AT&T, MCI, and Sprint were delighted with the Hollings bill and backed it with uncharacteristic unanimity, running joint full-page ads in support. The Baby Bells took to the broadsheets too, with ads promising lower long-distance bills if only consumers would bombard their Senators with telegrams demanding immediate freedom for their local company to compete in long distance. Perhaps unsurprisingly, given the lobbying power of the Baby Bells, the Senate is tiptoeing away from the Hollings bill toward a compromise similar to that passed by the House in June. Long-distance and cable-TV companies would have permission to enter the local phone business right away. Baby Bells would be allowed into the long-distance and cable-TV businesses once they arranged to sell local carrying capacity to competitors and got clearance from federal and state regulators. That could take at least a year. To ensure that the nation would still enjoy universal phone service, the bill would set up a fund to which all carriers would contribute. The size of the fund has yet to be determined; its purpose would be to keep rates for basic residential service uniform and low. Money would flow from the fund to phone companies that operate in inner-city neighborhoods or sparsely populated rural areas, where costs tend to exceed revenues. The fund would also ease the initial shock of competition for the Baby Bells by discouraging their rivals from cream-skimming in the local markets. If AT&T offered local service in Chicago, for instance, it would be eligible for payments from the fund only if it served the whole city, not just the Miracle Mile. The press of other business in Congress may delay the legislation until the next session. But spooked by the Hollings bill, the Baby Bells don't trust Congress to do right by them anyway. By the time the compromise surfaced they had already taken their fight to another front.

-- A MYSTERIOUS LAWSUIT. It was both stunning and quixotic. In July four Baby Bells -- Bell Atlantic, Nynex, Bell South, and Southwestern Bell -- asked a judge, in effect, to abolish himself. Their joint lawsuit petitions federal judge Harold Greene -- who for the past decade has supervised the consent decree that broke up Ma Bell, who rules on which businesses AT&T and the Baby Bells can and cannot enter, and who has thus wielded more power over these companies than Congress, the FCC, and the 50 state public service commissions -- to set aside the consent decree and declare that his services are no longer necessary. Observers are so taken by the chutzpah that they don't know whether the suit is serious. Most agree that its coincidence with congressional deliberations is no accident. With the House moving toward letting them compete in long distance, maybe the Baby Bells felt the time was right to try to throw off court-imposed shackles as well. Or maybe the suit is symbolic, the Baby Bells' way of letting Congress know that if it doesn't give them their way they will seek relief somewhere else -- the courts, the FCC, or the state commissions. As Eli Noam, director of the Columbia University Institute for Tele- Information, says, "In this country there are plenty of forums to shop around." You won't be surprised to hear Bell Atlantic CEO Raymond Smith insist that he and his partners are straightforward: "This is not a suit concocted to influence Congress. This suit was designed to win." In fact, Bell Atlantic has succeeded in court before. Two years ago it made an end run around Judge Greene by going to a federal court in Virginia and winning the right to own video programming and transmit it in the company's region, a Baby Bell first. But the chances of winning aren't nearly as good this time. Congress will almost certainly decide the issue before the courts can act. Assuming Judge Greene doesn't simply step aside -- unlikely, says consultant John Malone of Eastern Management Group in Parsippany, New Jersey -- the Baby Bells can't go to the court of appeals until he rules. Malone adds: "The first thing Judge Greene probably did was check the liquor cabinet to see what the Baby Bells had been drinking." The judge has said he doesn't think he should rule while Congress is considering major changes in telecommunications law. By the time this suit finishes cooking, the meat will be falling off the bone. The lack of unity among the Baby Bells is not auspicious either. Only four of the seven joined the suit. And while the abstainers have all cleared their throats supportively in public and reserve the right to join later (that is, if they see it ever has a hope in hell of succeeding), none believes it makes the best use of their legal budgets now, and at least one thinks the exercise pretty near pointless. Says Pacific Bell CEO David Dorman: "We didn't join because our counsel didn't see a winnable play. I think the lawsuit is ((born)) of exasperation and frustration." For the Baby Bells, the legislature and the judiciary seem to be moving in slow motion, which means the companies have little hope of feasting on long- distance revenues for years. With local revenues growing at only 3% a year or so, they must look elsewhere for new growth. Thank goodness, then, for the executive branch and its big auction of the sky.

-- BIDDING FOR THE FUTURE. "Imagine the NFL draft, complicated by ten orders of magnitude because you have not just a single team selecting a player but combinations of teams bidding. There'll be great big boards up and computer printouts and teams scurrying around saying, 'We have a tight end and these dodoes have three quarterbacks; what are they going to trade them for?' It's probably the largest implementation of game theory that's ever existed. The number of permutations and combinations is gigantic. For all intents and purposes, as they used to say when they taught mathematics the wrong way, it's an infinite set. The only difference is, it's real money and it's real companies." What Ray Smith is talking about is the first large-scale auction of radio frequencies ever held in the United States. As AT&T concluded when it agreed to swap some $12 billion of stock for McCaw, wireless technology is another way for phone companies to entice the individual customer, either at home or when roaming about. For the Baby Bells, winning control of a large swath of these frequencies is crucial if they are to build revenues and minimize their loss of market share as local markets open up. Baby Bell executives go weak when they think what could happen if cellular phones become a hit in the mass market. Right now the companies derive only about 10% of their revenues from cellular calls -- perhaps $8 billion a year -- but the rate of growth is astonishing. According to figures from S.G. Warburg & Co. in New York City, cellular revenues rose 40% in the past year, while other Baby Bell revenues grew only slightly. The operating profit on cellular calls is nearly 25%, vs. 20% for the business as a whole. The auctions will revolutionize the industry chiefly by adding masses of call-carrying capacity, more than tripling the available spectrum. For users of ordinary cellular service, this should mean that getting through will no longer be the crapshoot it often seems today. The new spectrum will also give cellular operators room to offer a broad range of so-called personal communications services (PCS) that promise to make mobile communications even easier. Some will be new twists on current products, such as pagers that automatically tell message senders that their missives were received. Others will be digital innovations worthy of the Batmobile, such as an electronic dashboard display that will let a driver push a button for a map showing, say, every restaurant with Tex-Mex cuisine on his route, the information delivered via radio transmitters that can pinpoint the location of his car. The government decided to auction off the frequencies so it could avoid reliving an embarrassment in which it unwittingly handed windfalls to speculators and profiteers. When the FCC established rules for the creation of the cellular phone industry a decade ago, it followed the precedent of radio and TV licenses, which had been given free to the original operators. The rationale was that an auction would exclude anyone who lacked money, including entrepreneurs whose creativity the new industry would need. So the FCC awarded some cellular licenses on the basis of lengthy applications and some in a lottery, and gave away the rest to local phone companies. In this way, the thinking went, the greatest possible number of Americans would have a chance to help develop what was, after all, the electromagnetic property of the nation. As it turned out, however, many of the winners knew nothing about telecommunications. They simply sold their franchises for their rapidly escalating market value. The licenses ended up in the hands of companies with a lot of money anyway.it might be more effective to end this sentence with a quote. This time the government is auctioning the licenses and putting the money into the fisc. The largest batch of frequencies, for franchises in the 50 biggest U.S. cities, will come under the gavel in Washington at the end of the year. They could bring upwards of $15 billion -- a sum on the scale of the biggest merger and aquisition deals of the Eighties. Even that figure may be too low. At an FCC auction in July, national franchises for ten tiny slivers of spectrum brought in over $600 million -- twice as much as expected. Though the slivers are too narrow to carry anything but beeper messages, the bidding went so high in part because the licenses were for national franchises and in part because digital technology lets you do a lot with a little bit of airspace. Compared with multibillion- dollar infobahn projects, which involve digging up roads to lay fiber-optic cable, the cost of building a nationwide two-way paging network is minuscule -- probably less than $100 million. In the next round of auctions, licenses for swaths of frequency in choice markets may fetch as much as $200 million apiece. July's big winners -- McCaw and PageNet, a Plano, Texas, paging company -- will face stiff competition from the Baby Bells, which for the most part sat out the first round. Bidding should be especially intense for licenses in California, where cellular systems are overloaded. Pacific Telesis is almost sure to be a high roller: It is committed to reinvesting its assets in its home state and even spun off its cellular systems this spring in anticipation of the auction. (Bidders will be allowed to buy only a small amount of spectrum in areas where they already hold a cellular license; others may buy four times as much.) Look for high bids by rivals who have no real intention of doing business in California but who want to deplete PacTel's war chest. Consumers will probably have to wait at least until 1996 before they see a change. The auction itself will be divided into several rounds of six to eight weeks and will take months to complete. After securing their licenses, winners will begin to install new radio transmitters incorporating up-to-date digital technology. The first tangible benefits should be that more calls get through and quality improves. But consumers will need new phones, since present-day cellular sets won't work over the new frequencies. Manufacturers will produce a new generation of so-called dual-mode phones that can operate over both sets of frequencies and can double as cordless phones in the home. For successful bidders, digital cellular and PCS services could turn out to be gold mines. Or they could grossly overpay and end up losing their shirts. In some cities the number of cellular licenses will leap from two to five; no one knows how low the added competition may drive prices. Stephen Boyd, chief of PCS for US West, says that in the heat of the bidding, a $100 million mistake will be all too easy to make, "and that sort of error can run a business out of business."

-- THE BABY BELLS BOND. For the first time since the breakup of Ma Bell, her offspring are making major deals with each other, aligning themselves in a way no one would have predicted even a year ago. With the auction looming, the deals are born of eagerness for the digital wireless future, and also of fear -- of being outbid for new spectrum in their own regions, of missing opportunities away from home, of being overpowered by larger rivals with deeper pockets. The alliances aren't short-term working arrangements, either, but mergers of the fastest-growing parts of their businesses. In June, Bell Atlantic and Nynex announced that they would combine their cellular companies; they are rumored to be talking with Ameritech about making it a party of three. In July, US West and AirTouch, Pac-Tel's spun-off cellular business, formed their own pact. The foe they fear most is AT&T. In July the Justice Department approved its purchase of McCaw Cellular Communications, a deal ratified by the courts in August. That created the specter of a wireless power with nationwide presence and terrific brand-name recognition -- huge advantages as the wireless industry seeks to develop a mass market. MCI's announcement last winter that it would buy a big stake in Nextel, a radio dispatch company that is developing digital wireless services, added what looked to be another wireless behemoth. Though that deal has apparently fallen through, it helped prompt most of the Baby Bells to conclude that they needed to team up. Their alliances reflect powerful economic imperatives. In separate interviews about their deal, Stephen Boyd of US West and AirTouch chairman Sam Ginn each cited the need for "scale and scope" to keep wireless operating costs competitively low. Added geographic reach will also assist the Baby Bells in negotiating with national retail chains like Circuit City. Increasingly, consumers go to such stores to buy phones, pagers, and other telecommunications gadgets, and to arrange for cellular and beeper services. Since the retailers prefer to deal with as few suppliers as possible, national carriers have an edge. Do wireless alliances foreshadow outright mergers between the Baby Bells? Don't bet on it. Most Baby Bell executives view consolidation with distaste. Jokes Amy Wohl, editor of TrendsLetter, an information technology newsletter: "The Baby Bells are like Victorian maidens. They're afraid that if they don't get married they'll be spinsters forever, and if they do get married they'll have to have sex." In fact, they may not need to merge. Each company has already achieved economies of scale in its ordinary phone business, and each has its own timetable for building the information highway. What's more, as they and their counterparts in the cable-TV business have already discovered, hooking up is hard to do.

-- PHONES AND TV ACTUALLY CONVERGE. During the two nanoseconds between the conception of the term "information highway" and its birth as a cliche, the notion of the full-service communications company also emerged: Behold, a monolith that would deliver phone calls, cable-TV programs, movies on demand, and home shopping services over seamlessly integrated digital networks. Ideas about how such omnipresent companies would form have changed with every season. First they were to be the product of a bloody war between cable- TV and telephone giants, each racing to transform its network into a fiber- optic highway and capture all the business for itself. Then came detente, as cable and phone companies made deals to merge, share networks, and compete against other telephone and cable combos. Most of the deals lasted about as long as a quark in a particle accelerator. What has endured is the urge to cross over -- phone companies into video, cable companies into phones. And finally, like the crossopterygian crawling - tentatively out of the water and discovering it had lungs, the first crossover ventures will soon open for business. As it happens, they are small creatures. Time Warner, which owns the No. 2 cable-TV company (and also owns FORTUNE's publisher), will offer phone service in Rochester, New York. Bell Atlantic is building a video network in Dover Township, New Jersey. The enterprises show that crossing over requires exquisite patience. For Time Warner, though retrofitting a cable-TV system to carry phone calls is numbingly complex, the toughest part is the human factor -- making deals with competitors, handling regulatory logistics, and marketing. The company's biggest coup may have been finding a phone company that would let it hook its cable system to the telephone network at all. Rochester Telephone, a midsize independent phone company that serves 370,000 customers, will let Time Warner connect to its network. In the deal, which state regulators brokered to foster competition, the phone company even agreed to provide $1 million of free call- forwarding services for customers who switch to Time Warner. As quid pro quo, Rochester Telephone expects the regulators to let it restructure so it can enter new businesses.have they agreed to do this? Life will seem surprisingly ordinary inside the home for Rochesterians who opt to buy phone service from the cable company. They won't be plugging their telephones into the back of the TV but rather will use the same phone jacks they have today. Wires already extend from each jack to a Rochester Telephone box on the side of the house; Time Warner will wire this box to one of its own, connected to its network. So little will change that getting people to sign up may be the biggest challenge. As Time Warner Communications president Tom Morrow says, "People are very uncomfortable with change." His task is complicated by the fact that Time Warner wants to charge about the same as the phone company. He is trying to decide what come-ons would work: letting local calls cover a larger geographic area, offering a second line at big discounts, or offering call waiting for free. The network will be up and running by the second half of next year. The phone companies face a hard crawl into TV. After a lengthy wait, Bell Atlantic finally got the FCC's permission to build the first large-scale video network of any Baby Bell. The system that will serve 38,000 households in Dover Township will work much like an ordinary phone system. Switching video + signals in such a network is many times more difficult than handling phone calls because of the huge amounts of data involved. Rather than select all programming itself like a cable-TV operator, Bell Atlantic will provide so- called electronic gateways that allow entertainment, home shopping, and other video-services companies to feed signals into the system. Progress has been achingly slow. Even though it now has the right to own and transmit video programming in its area, the company has to ask permission from the FCC each time it wants to build a local video system. If it wants to expand into an adjoining town, it would have to ask again. Says vice president Mark Wegleitner: "It has been a frustrating experience." The FCC is currently sitting on more than two dozen video applications from Bell Atlantic and other local phone companies. Still, chairman Ray Smith is sanguine about this venture. It's a step toward making Bell Atlantic one of those monoliths that will provide cellular, long- distance, local, and TV services, so customers will never need to patronize a competitor. Not a monopoly, mind you, but one of a handful of giants that will make up the next great business oligopoly. In talking about the wireless future, he revels in his luck to live in an era when almost every company will do well, a sentiment that has not existed in the American business psyche for a century. He says: "In the 1890s, everyone who started a steel mill died rich -- the ultimate objective of all American capitalists." Careful, Ray. If you get too big and too rich, people will starting hating the phone company again. ANDREW KUPFER can be reached by E-mail care of rsookdeo fortune.timeinc.com

CHART: NOT AVAILABLE CREDIT: FORTUNE TABLE/SOURCE: S.G. WARBURG & CO. CAPTION: WHY THE BABY BELLS ARE RUNNING SCARED The local phone business is bigger, but long-distance companies are growing faster and nipping at the Baby Bells' most lucrative operations. Baby Bells Major long-distance companies