MARKET WATCH: What's Happening? AT&T’s planned acquisition of Time Warner has disappointed investors--and riled up consumer advocates--who say that bigger is not better when it comes to media conglomerates. Amid this widespread dissatisfaction, it’s fair to wonder why the two companies are pursuing a deal at all.
Our Take: AT&T and Time Warner executives are betting on several synergies that promise to make the deal a winning proposition. Time Warner is eager to gain a foothold in the nascent online content business. AT&T sees the acquisition as a way to creatively package its existing services, boost advertising revenue, and invest in new mobile-based initiatives.
Telecom giant AT&T (T) is getting even bigger: Last month, the company announced plans to buy entertainment heavyweight Time Warner (TWX) for $85.4 billion. If the deal goes through, AT&T will own not only the “pipeline” through which consumers access entertainment content—but also will own much of the content that flows through those pipes.
Sure, this deal isn’t the first time that a content disseminator has purchased a content creator. Back in 2013, Comcast (CMCSA) became the sole owner of NBCUniversal. Then, in April of this year, Comcast purchased DreamWorks Animation for $3.8 billion.
The planned acquisition hasn’t had a warm reception. Consumer advocates worry that it will be Comcast-NBCUniversal all over again—a deal that they say failed to lower prices or raise market competition. Investors, meanwhile, have been bearish on the deal’s prospects. Most think AT&T basically impaled itself on the price. Yes, Time Warner’s stock shot up by nearly 10% on the deal’s announcement. But AT&T sank by roughly the same percentage--and this matters because AT&T's market cap is over 3X larger than Time Warner's. Net-net, a massive $19.5 billion in combined market cap evaporated as a result of the merger announcement.
WILL THE AT&T-TIME WARNER DEAL BE APPROVED?
Consult the policy and economics textbooks, and they'll tell you that the AT&T merger should not pose any antitrust problems. The Justice Department and the FTC put heavy scrutiny on anticompetitive “horizontal” mergers (which join two market competitors, like AT&T and T-Mobile or Comcast and Time Warner Cable), not on “vertical” mergers (which join two companies working on different levels of the supply chain, like Disney and Pixar or PepsiCo and Pepsi Bottling Group). But a growing number of legal voices are breaking from this received orthodoxy. In fact, buried in the footnotes, even the textbooks agree that there are a variety of good reasons for opposing vertical mergers—especially in industries, like this one, where costs of entry are high. Antitrust lawyer Steven Newborn contends that regulators are now “looking for the right vertical transaction to challenge.”
Donald Trump’s election further complicates the situation. On the one hand, with his populist ram's horn, Trump has declared that he will fight the merger and said it's "a deal we will not approve in my administration because it's too much concentration of power in the hands of too few." (He has also said, of the Comcast-NBC merger, that "deals like this destroy democracy and we'll look at breaking that deal up and other deals like that.")
On the other hand, it appears that most of the relevant regulatory agencies will be headed by appointees drawn from the traditional—and decidedly nonpopulist—free-market Republican pool that he defeated in the primary. From this pool comes Alabama Senator Jeff Sessions, top contender for Attorney General; former FTC Commissioner (and long-time Google consultant) Joshua Wright, who's heading the FTC transition effort; and Jeffrey Eisenach, who’s heading the transition team to fill the FCC.
The FCC could be a big potential problem because of its regulatory purview, which is much broader than just antitrust and extends to anything that could adversely affect "the public interest." Unlike the Justice Department or FTC, the FCC doesn't have the burden of proof. FCC officials could simply initiate hearings and a review process, at which time the acquisition would be effectively stuck in regulatory purgatory. But Hedgeye’s own telecom policy analyst Paul Glenchur notes that the two companies could avoid an FCC review altogether. How? Time Warner has one FCC-regulated TV broadcast station license (in Atlanta), as well as various satellite Earth station licenses, that would require FCC approval in order to transfer. If Time Warner were to dump these licenses, thereby avoiding their transfer (the jury’s still out on whether they will attempt this), the FCC would have no cause to weigh in.
Our take is that unless Trump (as President-elect or President) leans very heavily on current agency heads or his new appointees, the deal is very likely to go through. As for the FCC, Time Warner may be able to avoid "public interest" hearings.
WHAT’S MOTIVATING AT&T AND TIME WARNER?
Whatever the eventual outcome, the question must be asked: Given the widespread pessimism and the negative headlines that the acquisition is generating, what potential benefits are driving the two companies forward?
Time Warner: Goodbye TV, hello Web. For content creators like Time Warner and NBCUniversal, teaming up with content disseminators offers a hedge on an unprofitable TV business.
The bulk of revenue for content creators comes from TV ads and cable fees. In fact, Time Warner earns 85% of its operating profits from TV. But of course, as I’ve mentioned elsewhere, TV—along with its ad revenue—is in the midst of a long-term decline. More and more Americans are abandoning “linear” TV in favor of “over-the-top” streaming options that offer more flexibility at a much lower price point. (See: “In TV’s ‘Golden Age,’ Profits Are Harder to Find.”) This phenomenon has pushed media stocks into a slow downward glide—with the exception of Time Warner after its recent merger announcement.
Sure, content creators can, and do, go after this growing chunk of Web revenue themselves with standalone mobile apps. But merging with a broadband provider like AT&T gives them a direct pipeline to this world while also giving them vastly more scale than they could achieve with, say, an app like HBO Go. Judging by how investors treated the deal, this is the one clear-cut benefit they expect to see.
AT&T: Power goes to the content owners. But there are plenty of benefits on AT&T’s side of the equation that investors don’t see. First, new net neutrality rules make content ownership a major plus.
Under recently upheld “common carrier” regulations, broadband providers cannot favor certain content over others (through blocking, throttling, or paid prioritization). However, under so-called “zero-rating” programs, AT&T, Verizon, and Comcast all allow their own subscribers to stream certain content without it counting against data caps. These programs clearly violate the spirit of net neutrality, and are fodder for consumer advocates who say that market concentration is, in fact, hurting consumers.
How can this practice be allowed? As of now, there are no regulations barring zero-rating; such programs are reviewed by the FCC on a case-by-case basis. In fact, regulators currently are looking into—you guessed it—AT&T’s zero-rating program. But remember: A GOP-controlled White House and Congress may very well dismantle the entire net neutrality framework that discourages practices like zero-rating. Post-Trump, the prospects here have brightened.
AT&T: Building a user-friendly experience. A further benefit of content ownership is the powerful synergy that comes from being both the content creator and disseminator.
Having one company create and distribute a product or service makes for a vastly better customer experience. Programming created and brought to you by AT&T likely will have a sense of cohesion that disjointed competitors cannot match.
A good analogy is the iPhone: Apple can use its knowledge of how the device works to influence and improve its operating system, and vice versa. Google and Samsung share no such synergy, which is why Android phones often are criticized for being cumbersome and unintuitive.
AT&T: Squeezing more advertising dollars out of TV. Additionally, joining forces ensures easy access to customer data. Sure, AT&T and Time Warner could enter into a data-sharing agreement instead of merging. But the more data that are shared, the more complex this arrangement becomes. (Who’s to say exactly how much money AT&T’s data brings in as opposed to Time Warner’s data?) At some point, it’s simply easier to become one entity.
The implications of easy data-sharing are profound. Time Warner could sell to advertisers vast amounts of information about what AT&T customers are watching—which would then be used to create hyper-targeted ads. Former ad agency executive Tim Hanlon says that, “This deal could spark a break-wide-open moment for addressable advertising.”
To be sure, the FCC’s new opt-in rules force broadband providers to gain affirmative consent before gathering consumer data, which may limit the effectiveness of these programs. But perhaps AT&T could avoid these rules by offering its content through non-broadband services. And again, with Trump and a Republican-majority Congress, these regulations are in jeopardy.
AT&T: Staying ahead of the curve. Controlling multiple steps of the supply chain will enable telecoms to adapt quickly to a mobile-first world. AT&T CEO Randall Stephenson believes that the Time Warner acquisition will allow his company to build and distribute mobile content more rapidly.
What exactly have telecoms pinpointed as the next frontier of their business? High-speed, next-generation “5G” wireless. Stephenson says that he will be disappointed if his company is not competing with the cable giants on high-speed Internet and TV provision by 2021—a goal that hinges on 5G. For its part, Verizon (VZ) believes that it will be the first to cross the 5G finish line.
But this utopic wireless future may be further off than it appears. Unlike previous generations of wireless technology, 5G will involve more than just building more spectrum at existing cell towers, but will require creating millions of onsite access points. T-Mobile CEO John Legere practically scoffs at Verizon’s timetable, saying that it will be years before anybody is close to rolling out 5G.
Time Warner and AT&T: Generational change. A further accelerator pushing M&As like these forward is generational turnover. The rise of platform-agnostic Millennials makes it imperative for telecoms and content creators to become nimbler and smarter—for example, by creating unique service packages and giving consumers more flexible access to content.
Instead of viewing linear TV like their parents, Millennials are cutting the cord (if they ever had one) and streaming their favorite shows. A growing cadre of media outlets claim that cord-cutting is overblown. But make no mistake: It’s happening, and it’s costing telecoms a fortune. Industry tracker Leichtman Research Group reports that the 11 largest U.S. pay-TV providers lost 665,000 net subscribers in Q2 2016, up from 545,000 in Q2 2015 and 300,000 in Q2 2014. A survey by consultancy cg42 projects that cord-cutting could cost pay-TV providers $1 billion over the next 12 months.
Think of it this way: Telecoms from AT&T to Verizon to Comcast would not be rolling out “skinny bundles”—slimmer, cheaper bundles of channels—unless they felt they had no other choice.
REMAINING QUESTIONS…ASKED AND ANSWERED
We won't know for many months whether the deal will be approved—or what the two companies will have to concede in the process. But right now, the odds are favorable that we’ll see a combined AT&T-Time Warner. For one, this vertical merger isn’t your typical horizontal power grab that gets barred by regulators. Additionally, even if Trump is personally opposed to bigness in the media, he would likely have to override his appointed officials to block the deal—an unlikely prospect.
Assuming the deal passes, the big question is: Will the expected economies arrive? Very likely. This is not the one-sided deal that many investors see—it features many strong synergies for both sides.
Time Warner is hedging against a tough TV business that is killing the stock prices of other entertainment companies like Viacom (VIAB), 21st Century Fox (FOXA), and Disney (DIS). AT&T is gearing up for the new, content-driven future of telecom. Sure, firms like Charter Communications (CHTR) that have acquired massive “pipes” may look like a good buy. But the telecoms that have acquired the content to fill those pipes are the true winners.
Comcast’s purchase of NBCUniversal three years ago put it at an early advantage. AT&T is trying to join the fray, and the rest of the telecoms will likely try to follow—assuming that regulators and legislators let it happen.
