Musical Chairs in the Media Industry

With somewhat predictable frequency, the media, telecom and communications industries go through waves of consolidation every few years. Typically, such seismic events occur when interest rates are low, technology is changing rapidly (or even discontinuously) and valuations reach historic highs. Recently, a new wave has begun; a wave, however, unlike any in the past. The current wave involves the very biggest companies in the communications industries; and the logic behind the transactions ranges far afield from the strategic considerations of the past. 

This time around the landscape is also unrecognizable from prior consolidations. Broadband subscriptions are racing past video subscriptions. Advertisers will soon spend more on social media outlets than over the air broadcasters and cable networks. At the same time, video streaming services will compete on equal terms with the best programming offerings of any legacy programmer.  The demand for streaming services has already out stripped the capacity of existing wired and wireless networks.

The fencing matches among big players involve a great deal of thrust and parry. While we list eight deals, two have already been withdrawn: Murdoch’s offer to acquire Time Warner Inc. and Sprint’s offer to merge with T-Mobile US. In the former case, financing and resistance from TWX’s management stymied the Murdoch offer, while in the latter case, the poor prospects for passing required regulatory approval seems to have been decisive. (Whether these offers are permanently withdrawn isn’t clear, in the former case, it is possible that Time Warner could attract other bidders, while T-Mobile already has an underbid from Iliad of France.)

Why all the strategic maneuvering among media players? Is this not some kind of chair shuffle on a sinking ship or is there more to it?

Below, we lay out a table of the current media deals that have been publicly announced.

As usual, the publicly stated rationale for each deal seems to center on bromides (disputed heavily by bloggers) proposing to serve better subscribers’ or viewers’ interests; or, for the investment community, to enhance growth. By and large, however, it is clear that this round of consolidation is motivated either by a need to eliminate cost and/or to gain scale. It is an all-out race for dominance and for ever greater negotiating power. So, the question remains, why? Are we seeing further value being created or an industry cannibalizing itself?What are the common themes?

In prior waves of consolidation, shareholders of both buyers and sellers tended to benefit (particularly in stock deals) as demand by advertisers and consumers for greater media choice fueled growth in fundamental measures-(e.g. subscriptions, advertising and revenue). Consolidation often, though not always, was further accompanied by increased efficiency and pushed higher margins in merged companies.

This time, it seems,  we don’t see significant growth opportunities, merely attempts to gain margin.

Here are a few of the common themes we see in the current round:

• Seeking scale to combat fading growth or declines. Virtually every segment in the media industry faces declines in viewers, subscriptions, and advertising (arguably HBO is an exception). For some while, players have attempted to extract greater revenue per subscriber with rate or price increases. Cord cutting (either of cable TV services or landline telephone services) suggests that such strategies  won’t work forever in the newly competitive media world. So, many of the above deals suggest a limit to further growth in penetration or usage and reflect an impulse to extract margin gains from more effective bargaining with suppliers or distributors. After both sides consolidate, however, everyone is back to point A and all face the prospect of further value erosion.
  
  
• A new round of capital expenditures on the horizon in both wireless and wired communications. Most existing cable and wireless infrastructure is obsolete. The set top box is evolving into a home gateway device. Network speeds average 15 megabytes down and 5 up on most systems but plant network speeds have already reached 1 gigabyte in markets like Austin. ATT, Time Warner, Verizon and Comcast are boosting networks speeds both upstream and downstream to well over 300 megabytes. Capital expense is rising rapidly to meet the new build requirements.
  
  
• A new escalation in programming expenditures will also siphon cash flow from programmers and content providers. Netflix, Amazon and Hulu video streaming services have had terrific early success in in creating and launching new programming, such as House of Cards and Orange is the New Black. As has been the case with every expansion in media choices, programming cost should rise as actors, producers and writers see their bargaining positions strengthen.
  
  
• Increasing demands by investors for dividends or incumbent entrepreneurial families looking to cash out through dividends or other financial structures. ATT and Verizon are dividend payers, which retirees or pension managers rely on, while Viacom, Cablevision and Comcast have incumbent entrepreneurs who need to cash out for state or other purposes. Where is the cash going to come from to pay out the legacy holders while competitive pressures demand higher cape ex and program investments?
  
  
• A willingness to try new tax reduction strategies. The Windstream Proposal shook the telecom and financial community when it announced that it is spinning off some of its network assets into an independent Real Estate Investment Trust (REIT), then leasing them back to remove a layer of federal tax liability. Partnerships to reduce tax liability have been used in the media industry before: Metromedia and the original Time Warner were good examples, but these vehicles tend to have a short shelf life as the IRS typically moves quickly to shut such loop holes. Like Master Limited Partnerships in other industries, such tax strategies are best employed in mature or declining industries. In the Windstream proposal we see an umbrella vehicle that can be used to liberate cash in future acquisitions, simply by bringing targets under the Windstream umbrella.

Is there an urgent investment recommendation here?  Not urgent, but cautionary.  While scale and tax reduction may improve cash flow (or at least stem declines) in the short term for many of the proposed combinations, we doubt shareholders will benefit in the long term. Shareholders in a newly consolidated industry may have to look for other value creating vehicles outside traditional media players.