Telcos Swing and Miss in Media
The streaming wars started years ago and the market has only taken more of the spotlight since the pandemic. Netflix started the charge, Amazon built out a studio, large telco companies acquired their way in, and late entrants like Quibi flopped. Some insight into how the media business works comes from examining why Amazon and Netflix have succeeded while AT&T failed, as demonstrated with the recent spin out of WarnerMedia. This article highlights the overall mechanics of AT&T’s exit from the media business with the divestment of WarnerMedia, and then analyzes the strategic underpinnings of the media industry and the differences in business models between telco and media companies.
Overview of the AT&T Deal
On May 17th AT&T announced it’s spinning off its media business WarnerMedia at a value of $43B and merging it with Discovery to create a major new player in the entertainment world which will compete with the likes of Netflix, Disney, and Amazon Studios. The combination of the two will create the world’s second largest media firm by revenue after Disney, with an enterprise value of $132B reports The Financial Times. The new company will be led by Discovery CEO David Zaslav and combines big names in entertainment like HBO, CNN, and HGTV. While the boards have approved that deal, it has not yet been signed off by regulators and the two companies have stated they don’t expect to close the deal until mid-2022.
Telco Moving into Media — Strategic Implications
While the mechanics of the deal are not unusual, the historical context and evolving playing field makes for an interesting study in business strategy. This recent deal follows a trend — phone companies that tried to establish a footprint as media conglomerates now divesting their media assets. In July 2015, AT&T acquired DirectTV for $48.5B. In October 2016, AT&T acquired WarnerMedia (then known as Time Warner) for $85.4B. The deal was held up in court by the Justice Department, but in 2018 it was finally approved. Now, both deals are being undone at massive losses. In February, AT&T announced it was spinning off DirecTV, with the new firm valued at $16.25 billion and as mentioned, WarnerMedia is now being sold off for $43B. It’s worth noting AT&T is not the only one. Earlier this month, Verizon announced it had sold off AOL and Yahoo to Apollo for $5B, about half what Verizon originally paid. It’s easy to say in retrospect that all these acquisitions were poor decisions, but what was the intent?
For that we have to take a closer look at AT&T’s fundamental business model, particularly as it relates to distribution. For telco providers, distribution is the physical infrastructure of cable, fiber, and cell towers that often runs alongside power lines and cell towers. The up-front capital required to install this is significant, but it scales well per customer, is relatively cheap to maintain, and also serves as a strong competitive moat. It takes a lot of capital to enter the market, and even if a competitor decided to lay cable alongside their lines, they could decrease cost so as to price new entrants out of the market.
As a mature industry today, there are only a handful of players in the market and to the extent that competition exists, we’ve actually seen pricing utilized as the primary differentiator. T-Mobile has largely used this strategy over the last decade to gain market share from both Verizon and AT&T. With price as a primary differentiator, operational efficiency at economies of scale becomes increasingly important.
In 2019, activist investor Elliot Management took a $3B stake in AT&T and in an open memo noted several improvements that could be made to increase the share price ~80%. They state, “Elliott believes that through readily achievable initiatives — increased strategic focus, improved operational efficiency, a formal capital allocation framework, and enhanced leadership and oversight — AT&T can achieve $60+ per share of value by the end of 2021… AT&T has been an outlier in terms of its M&A strategy: Most companies today no longer seek to assemble conglomerates,” the fund added. “We firmly believe that AT&T’s M&A strategy has not only contributed directly to its profound share price underperformance, but has also caused distractions that have contributed to the company’s recent operational underperformance… AT&T has yet to articulate a clear strategic rationale for why AT&T needs to own Time Warner.”
Elliot’s rational follows popular thinking amongst most shareholders, but it doesn’t explain AT&T and Verizon’s perspective. It’s likely that leadership found themselves in a legacy industry suffering a price race to the bottom and saw content as a means of differentiation from competitors. However, the fundamental flaw is in the orthogonal relationship between telco and media as it relates to business models and distribution.
In telco, laying cable is expensive upfront but is cheap to maintain and is a fundamentally economically strong business that scales well. The distribution (physical infrastructure) is also owned by the cable company — it’s AT&T or Verizon’s — not shared. This means it’s also zero sum — there are typically no AT&T and Verizon customers. On the other hand, content companies require large sums of continued production investment, and the means of distribution is the internet — a totally decentralized system that no one owns. When a telco company acquires a media asset, the capital they have already invested in infrastructure doesn’t help the media business in an additional way; it’s effectively a sunk cost. Furthermore, AT&T can’t justify making WarerMedia’s content exclusive to AT&T’s customers. Doing so would kill the business overnight. Media companies need certain levels of scale to justify the upfront cost of production and this move would instantly cut off a huge portion of current WarnerMedia customers. Furthermore, in a content rich market with so many options, only a small percentage of customers would likely switch their internet provider just so they could watch HBO or one of WarnerMedia’s other programs.
As such, the market is set up so that Verizon customers still have access to HBO and WarnerMedia’s other assets. Additionally, unlike the telco industry, the media competitive landscape is not zero sum. Consumers have continued to show that they are willing to own Netflix, Amazon, and HBO subscriptions concurrently. Net, there are little to no synergies between the businesses. It makes sense for a high growth media company like Netflix to invest billions in content production to fuel its subscriber growth, but a telco investing in content doesn’t serve as a differentiator or garner a tangible strategic advantage in attracting more telephone customers.
As an aside, this is notably different from Amazon’s entrance into media and recent announcement to acquire MGM. Unlike a telco provider, Amazon’s distribution network is hybrid. It’s both the internet — the same rails that content businesses use — but also includes their warehouse centers and broader logistics lines. The primary difference between the categories is in what drives buying decisions for customers, or top line revenue. Unlike the choice between AT&T or Verizon which is zero sum and driven by geography and price, e-commerce is anything but (sometimes I shop etsy, sometimes I shop Amazon). Amazon grows its top line by driving site-traffic, purchase conversions, and through its prime subscription offering. As such, it’s reasonable to argue that investments in media content draws more people to the site, increasing the likelihood of purchase conversion, and also increasing the value proposition of its prime subscription offering. Many argue Amazon shouldn’t be in the media space either, and that they paid too much for MGM, but at least there are some synergies.
Moving back to AT&T and beyond the strategic fundamentals, there were also notable gaps in leadership that led to an exacerbated failure of the acquisitions. As noted by the WSJ, “top executives at HBO, Warner Bros. and parts of its Turner broadcast networks left after the AT&T takeover. Mr. Stankey said his goal was to break down the silos between the former divisions of Time Warner, so they could work together to propel the streaming plan.” This clearly didn’t work. Cable mogul John Malone, a major Discovery shareholder, said that although he believes Time Warner is doing fine, merging content and distribution usually doesn’t make sense. “I think that the technology of connectivity and digital technologies are one focus, and creating content that people get addicted to is another focus,” he said. “And you seldom would find both of those in the same management team.”
This led to fumbles in execution. When the start of the Covid pandemic triggered a surge in streaming in March 2020, WarnerMedia hadn’t yet launched HBO Max. That service launched in May, after rivals like Disney and Netflix had been racking up new subscribers. Production shutdowns also made it tough for the service to get new content ready (WSJ). Furthermore, their marketing of the HBO Max service was abysmal. Customers couldn’t understand how HBO Max was differentiated from the HBO channel, HBO Now, and HBO Go.
Now, Verizon and AT&T will go back to their roots — wireless and broadband businesses. For them, the major opportunity for improved margins and differentiation is in 5G, and they will likely continue to double down in the category.
Hope for the New Entity?
It’s at least easy to see the synergies between WarnerMedia and Discovery. The combination of the two will become the world’s second largest media firm by revenue (after Disney) and the companies expect to save about $3 billion annual from synergies between the two businesses, which they say will be invested back in content. As it stands today, Zaslav (named CEO of the combined entity) told investors on a call that WarnerMedia and Discovery spend $20 billion on programming — more than Netflix in its most recent budget. What’s still unclear is how Zaslav and leadership will re-package this content together. One obvious possibility is a bundled subscription or tiered packages for its extensive program library.
M&A works best when there are clear benefits that are unlocked: reduced cost by greater economies of scale, operational synergies, and access to new customer bases that provide the opportunity to cross/up-sell for example. Telco and media companies are quite different in nature. They effectively have no cost-saving operational synergies and because customer buying decisions are notably different in these categories, the upside opportunities with those customers are minimal. While it’s always easy to comment in hindsight, telco giants moving into media seemingly had little hope from the start.
Life is full of adventure,