(FORTUNE Magazine) – Now starting his second year on the job, AT&T CEO Dave Dorman has a sense of history, a sense of humor, and, increasingly, a sense of urgency. AT&T's revenues and workforce are shrinking dramatically as its primary business--long-distance phone service--is under attack from traditional and Internet competitors. And it recently warned that sales would fall short at its crucial business-services unit. Adding insult to injury, Ma Bell has persistently been rumored to be an acquisition target, most recently by BellSouth, one of the so-called Baby Bells. FORTUNE caught up with Dorman recently to get his take on AT&T's future.

--Adam Lashinsky

So when does AT&T stop shrinking?

Communications as an industry is not going away. We're not making buggy whips here. The principal problems facing the industry are a result of the excess capacity built during the bubble, when the industry invested at a rate of 40% of revenue for four straight years. With the hype around the Internet going to the moon, we just overbuilt the crap out of the industry's infrastructure. We have 19 large telecom companies in the U.S. today that all theoretically can do a lot of what the others do. If you go back even to 1996, we had only ten companies--and we didn't all do the same thing.

So what happens to all these companies now?

I think there's going to be more failures and destruction of assets. And even as the strongest companies get weaker, they're going to say, "Look, if we combine with Fred, we can take more cost out and have better scale." So I think you're going to end up with some very big-scale players who have surviving financial models, and pricing stability will return. I don't think pricing power improves, but technology will provide an opportunity to take costs down and boost margins.

When does this shakeout begin, given that AT&T is forecast by some analysts to have declining revenue through 2007?

I believe the macro conditions in telecom will take a couple of years to work themselves through, assuming that the government does not impede change.

And is AT&T going to be one of the survivors?

At $35 billion in revenue and a terrific brand, AT&T has the ability to be a survivor, although we may look a bit different. Our name may be on a bigger company or we may be more focused on fewer markets where we have real advantages.

So you're acknowledging that you've tried to sell the company, as has been widely reported?

AT&T's market capitalization is $15 billion. Verizon has a market cap of $100 billion, SBC's is $90 billion, and BellSouth's is $50 billion. It's pretty clear from those numbers that I'm not going to buy them. So bankers, analysts, and others speculate that AT&T is not going to be an acquirer, and that's why it gets spun that way.

So have you held any talks?

We've consistently said "no comment."

Let's talk about Internet-based phone service [known as "voice over Internet protocol," or VOIP]. Isn't that competition going to be even more brutal than long distance?

It will be. But we have 40 million customers in the consumer market. We operate the largest IP network in the world in terms of daily traffic. People say, "What about Vonage? Don't they have an advantage?" And I say, "Well, given the fact that they don't have a brand, they don't have any capital, and they have no unique proprietary technology that I can't reinvent or buy from the same people they buy from--no, I don't think they have unique advantages over AT&T."

How does it feel to be CEO of AT&T at a time like this?

We have been through a very painful period. But people would never have dreamed that we could have done as much with cost and innovation as we have by necessity over the past three years.