(FORTUNE Magazine) – CRITICS WERE nearly apoplectic when the Justice Department, citing antitrust laws, moved to break up the phone company. The laments echoed across America: Why mess with a telecommunications system that is the envy of the world? As the fifth anniversary of the AT&T divestiture rolls around on January 1, that carping seems, in retrospect, ill-considered. Today the great majority of the country's telephone customers, large and small, declare themselves satisfied with the service they receive. Despite predictions that AT&T would pummel its fledgling competitors, the industry has evolved into an entrepreneurial, freewheeling marketplace where customers and many shareholders reap big rewards (see table). Most important, the new competition has forced rapid technological change, in fact, a flowering of communications research. Says William McGowan, chairman of fast-growing MCI Communications: ''Divestiture was essential. If we had not done this, the U.S. would now be at a competitive disadvantage with the world.''

WHO WON AND WHO LOST? The breakup's blessings have not been bestowed with absolute uniformity. The divestiture order allocated more expensive long-distance service -- which had traditionally subsidized cheaper local service -- to AT&T. At the same time the order put local customers in the hands of seven regional holding companies, the Baby Bells. This separation was expected to lower long-distance rates and raise local fees, and that is what has happened (see chart). What about customers who seldom use long distance? They include many of the 90 million residential subscribers and the 18 million small businesses. These folks are paying, on average, nearly 35% more for their local phone service than five years ago. But the rise has not been as steep as many had feared. The more pessimistic critics were predicting that local rates would double in a few years and that many poor and elderly would be forced to give up their phones because of the higher cost. The Federal Communications Commission reports that phone service has expanded since divestiture. About 93% of U.S. households have phones, up from 91% in 1983, and the percentage is even higher for the over-65 age group. Judge Harold H. Greene of the U.S. district court in Washington, D.C., approved the consent decree between AT&T and the Justice Department, and as part of that agreement he has the job of administering it (see box). Though some critics, especially the Baby Bells, think he is too diligent in his task, only an act of Congress could turn it over to someone else. Responding to criticism about increased costs, Greene likes to recall in speeches that local phone rates had been going up at about a 6% annual rate before the breakup and that most of the big price rises are over. He also points out that residential subscribers and small businesses may well benefit from lower equipment costs. Before divestiture, most consumers leased phones, paying an annual rental fee of about $28 each. Now a cheapie model goes for less than half that, and even the top-of-the-line equipment costs little more than twice the old yearly rental charge.

For customers who use long distance a lot, of course, the picture is even rosier. Some corporations have sliced their communications costs more than 50%. Even with the big increases in local rates, overall phone service is only about 16% more than in 1983. Adjusted for inflation, the real cost for all phone service in the U.S. is a bit less than five years ago. Says Randall L. Tobias, vice chairman of AT&T: ''If you stand back and look at the total picture, you are hard pressed to find anyone who has been substantially hurt by divestiture.''

WHAT ABOUT SERVICE? Here again the pessimists were wrong. True, some residential subscribers and small businesses who loved their rotary dials may believe the new telephone features are not worth the higher rates. They may also face the increased hassle of dealing with several companies when they pay their bills or have a service problem. When a line goes dead, these customers don't know whether to call the local company or the store that sold the phone. If the problem turns out to be that cute Bulgarian-made phone they picked up on sale, the one that quacks like a duck and doubles as a microwave oven, they could get hit with a service charge. But the telephone system itself functions at least as well as in the past, and such technological advances as digital lines and fiber optics have improved service for many customers. Moreover, for many telephone users, divestiture has brought an extraordinary range of service options. AT&T used to offer barely half a dozen extra services, such as Touch-Tone phones and computer modem lines. Now the big long-distance carriers can provide over 100 options to customers -- everything from exotic conference hookups to international data transmission. Major corporations are now able to tailor their communications networks to specific needs, knowing they can count on suppliers eager to compete for their business. In a 1986 Gallup poll of diverse customers done for the U.S. Telephone Association, 84% of respondents rated post-divestiture service as either good or excellent. Another poll, conducted the same year by AT&T with the Consumer Federation of America and the American Association of Retired Persons, suggests that residential customers have adapted more quickly than expected to changes. More than 90% said they knew they had choices for long-distance service, 80% said they knew whom to call for problems with local service, 74% said they knew whom to call for equipment repair, and 68% said they found it easy to understand their bills. Corporate and government customers are equally pleased. A study last year by a Massachusetts research group tracked subscribers, each with an average of nearly 1,000 communications lines. Over 80% rated their service good or excellent, while less than 3% responded with a ''poor.'' Says William T. Esrey, president of long-distance carrier US Sprint: ''For big business customers, the bottom line is that intense competition works. They are getting better service at significantly lower prices.''

WHAT HATH COMPETITION WROUGHT? At divestiture, critics were convinced that industry competition, intense or not, would be short-lived. They argued that AT&T, allowed to stay in lucrative long-distance and equipment manufacturing businesses, had plucked the plums and would easily dominate any competitors in those fields. Many Wall Street analysts were dubious about prospects for the seven regional holding companies. The Babies, it was widely speculated, would have trouble making a profit without Ma Bell's management and technological nurturing. Record another ''incorrect'' for the doomsayers. The equipment business is populated by a gaggle of vendors from around the globe, aggressive marketers such as West Germany's Siemens and Canada's Northern Telecom. Hundreds of competitors have found safe niches in the long-distance market, and two of them, MCI and US Sprint, have become multibillion-dollar enterprises with the financial and marketing muscle to match up with AT&T. The Baby Bells, meanwhile, have generally topped Mom in crucial financial benchmarks such as total return. Ten shares of AT&T were worth about $615 at divestiture; the shareholder who hung on to those ten shares, plus the seven Baby Bell shares thrown in with them as part of the breakup, is now holding stock worth about $1,300. In fact, compared with some younger, nimbler players, AT&T has at times seemed more than a little clumsy. Weighted down with employees and unaccustomed to the thrust and parry of the open marketplace, the company reported disappointing earnings in the first several post-divestiture years. AT&T demonstrated its marketing naivete when it made a ballyhooed entry into the personal computer business. The company assigned its old-line sales force, used to dealing with captive customers, to handle unfamiliar high-tech products and grapple with entrenched competitors. The result: losses of around $3 billion. A modest turnaround began in 1986, as late Chief Executive James E. Olson slashed costs. Olson's successor, Robert E. Allen, 53, has maintained the momentum and instilled a more combative spirit in the once somnolent giant. Since 1984, AT&T has cut over $1 billion through employee reductions and plant modernization. Allen has tightened the focus of his sales force by creating strategic business units for specific customer groups; for example, manufacturers. The company, in December, won 60% of a multibillion-dollar contract to replace the federal government's telecommunications network. Even the computer division, still a money loser, got a big lift recently when it won a contract with the U.S. Air Force worth over $1 billion. AT&T will take a $6.7 billion write-down in the fourth quarter of 1988, mainly to replace aging equipment. Though the move will produce the first annual loss in the company's 103-year history, most industry experts applaud Allen's continuing restructuring efforts. Says John F. Malone, president of the Eastern Management Group, a consulting firm: ''AT&T has had to step up to the plate on some very disagreeable issues, and it has become a lot more business-like and aggressive as a result.'' What most concerns AT&T executives is hanging on to their share of the long- distance business, the company's lifeblood. ''I hope everybody here comes to work scared to death,'' says vice chairman Tobias. The company still controls about 80% of the market, but its fears are justified. First, competitors are making steady inroads. Second, the regional companies are asking Judge Greene for permission to get into the business. MCI, with about 10% of the long-distance market, has become the most formidable opponent. Its revenues have galloped at a 27% average pace since divestiture, vs. less than 1% for AT&T, and most Wall Street analysts are optimistic about its prospects. MCI chief Bill McGowan, 60, doubts that he can continue to post such phenomenal gains indefinitely. But he does like the earnings outlook as his company enters arenas previously dominated by AT&T, particularly international long distance. Says he: ''There is no safe harbor left for AT&T. We can do everything they do.'' US Sprint, a partnership between GTE and United Telecommunications, has also emerged as a strong long-distance contender. The company, soon to be controlled by United Telecom, has yet to report a profit, but its $3 billion fiber-optic network is in place, and its revenues for 1988 should be up an awesome 35%. Its long-distance share is about 7%.

WHAT DO BABY BELLS WANT? The seven regional companies continue to press for more freedom, particularly the right to be able to start their own information services, such as electronic yellow pages, in an effort to build on the considerable success they have had since divestiture. Like little princes, the Bells started life with obvious advantages. They inherited an average of $17 billion in assets and effective monopolies for local service in their areas. But the Babies have prospered beyond expectations by cutting costs, reducing debt, maintaining top-notch service, increasing earnings, lobbying vigorously and often effectively for more operating latitude, and even venturing into such unregulated startup businesses as computer retailing. Says BellSouth Chief Executive John Clendenin: ''All the sinister things, like fears about poor service and our finances going bad, have dropped by the wayside.'' Each of the offspring has grown at its own speed. Some, such as BellSouth, were blessed with booming populations in their regions, while others, like U.S. West, have been stunted by the costs of maintaining service throughout big-sky country. California, where Pacific Telesis is located, has been a bastion of pro-consumer commissioners who have been tough on rates. All the Baby Bells are in the top ten on FORTUNE's annual list of largest utilities, and all have performed well for their shareholders. Says John Malone of the Eastern Management Group: ''At divestiture investors were barraged with advice on which Baby Bell to buy. It turns out you couldn't have made a bad play.''

HOW ABOUT NATIONAL SECURITY? Before the breakup Pentagon officials argued that national security could be compromised in an emergency because they would not be able to use a single communications system to spread the alarm. Scientists grumbled that AT&T might cut funding or radically shift priorities at Bell Labs, long one of the world's premier research facilities. Experts differed with Judge Greene's assumption that more competition would spur advances in communications technology. In short, critics grossly overstated the harmful effects of divestiture on America's interests. Defense Department concerns were handled at the outset. During the years of hearings before the breakup, the brass had argued that a more fragmented phone system could spell disaster in case of a natural catastrophe or armed attack. ''We had the Bell System at our beck and call,'' recalls Lieutenant General William Hilsman, former manager of the National Communications System, the agency that oversees emergency preparedness. ''It took us two years to figure out what we would do if we couldn't call AT&T.'' The consent decree's answer was to order the Baby Bells to have a single point of contact. They set up an organization called Bellcore, which would function both as a research and engineering consortium and as a control center in the event of a national emergency. A National Sercurity Emergency Preparedness group within Bellcore makes sure the regionals can respond to everything from hurricanes to thermonuclear war. Some dozen Bellcore managers concern themselves solely with security issues, and a contact person also resides at each of the regional companies. Bellcore has already proved its mettle in weather emergencies like hurricanes and tornadoes. Some federal employees still yearn for the good old days. Says National Communications System deputy manager Ben Morriss: ''When companies are in competition with each other and trying to keep their costs down, they won't do certain things just for national security purposes. For example, each company installs less backup power for an emergency because it is more expensive.'' But outsiders argue that divestiture has injected some fiscal reality into the process. Says Kenneth Flamm, a senior fellow at the Brookings Institution: ''Now the Defense Department has to pay for what it wants, and that probably has the effect of making it get only what it really needs.'' Hardly anyone predicted the breakup's one clear negative impact on the national interest. The U.S. has become a huge open market for the global peddlers of telecommunications equipment, especially business telephones and other hardware. At the same time, many overseas markets are largely closed to U.S. products because of trade barriers or local monopolies. A $275 million trade surplus in telecommunications gear in 1982 had turned into a $2.5 billion gap by last year.

WHAT ABOUT R&D? Most fears about Bell Labs have turned out to be illusory. Despite the fact that AT&T's revenues have shrunk to about 50% of predivestiture levels, the company has pumped up its R&D budget from about $2 billion annually at the breakup to about $2.7 billion in 1988. To make sure that the institution that gave the world such inventions as transistors and laser beams remains at the leading edge, AT&T continues to devote about 10% of the Labs' budget to basic research projects with no immediate commercial applications. Bell Labs, which has received over 25,000 patents since it was founded in 1925, still wins on average a new one each day. Far more important for telephone users, competitive pressures are turning the concepts developed in the laboratory into products faster than before. About 30% faster, according to Ian Ross, president of Bell Labs. He says, ''If you walk around the lab, there is a greater sense of urgency about implementing technology.'' Divestiture has clearly accelerated the pace of some crucial new communications developments. One major example: fiber optics, which provide more capacity and clearer transmissions. AT&T had made long-range plans to put in digital lines, which include fiber optics. When MCI and US Sprint forged ahead with their own fiber networks, AT&T hustled to catch up, and by 1992 will have laid fiber throughout 94% of its system. The Baby Bells are still prohibited from manufacturing their own hardware under Judge Greene's order, but they can develop computer software through Bellcore. They are also largely liberated from AT&T's technological monopoly; they can buy from anyone, anywhere. Says Michael Kennedy, a telecommunications consultant at Arthur D. Little: ''You used to get a new service when AT&T was good and ready for it. The Bells had to queue up to get their new technology, like a bread line in Moscow.''

WHAT HAPPENS NEXT? AT&T is pushing for a major change in the FCC rules that govern its long- distance business. Now the company is limited to a maximum rate of return of 12.2% on investment. To please shareholders it wants the freedom to boost earnings as much as possible. Its competitors, MCI and US Sprint, have no such earnings restrictions, but the Baby Bells do. Their limits are set by the FCC and the states in which they operate. However, half the states are considering or have already put in changes. Many states are contemplating a cap on phone call charges instead of earnings. The FCC may soon do the same.

Questioning the level of the playing field, AT&T also complains about regulations that bar it, and not its competitors, from negotiating prices with big corporate customers unless the FCC approves. Meanwhile, the Bells want permission to get into growth areas outside their present purview -- such as manufacturing equipment, providing long distance, and generating information services such as electronic yellow pages and various data banks. Says Nynex Chief Executive Delbert Staley: ''If you think you can restrict us to being phone companies, then you are condemning us to death.'' But restraint may be the most prudent course for now. The price cap on call charges that AT&T is looking for seems a good idea; any business should have the right to earn its best possible return. But AT&T, with its huge market share, could still destroy its competitors by consistently undercutting their bids on big corporate accounts. The FCC should take another look at that situation when AT&T's competitors are a lot stronger. As for the Baby Bells, they could easily use their monopoly on local services to make a shambles of competition in such fields as long distance and information services. The Bells make a case for manufacturing: There is so much competition that it seems unfair to exclude them. But the FCC would have to make sure the manufacturing Bells do not use their dominance in an area to exclude other makers. Yes, Judge Greene and the Justice Department have been right and their critics wrong. But there could yet be big trouble on the line if changes come too fast and extend too far. The regulators were correct when they plunged ahead with divestiture five years ago. Now they would be wise to heed the maxim they chose to ignore back then: If it ain't broke, don't fix it.

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: THE UPS AND DOWNS OF TELEPHONE RATES

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: MA BELL, HER COMPETITORS, AND HER OFFSPRING