Is AT&T’s bid for Time Warner vague or Machiavellian?

THE proposed takeover of Time Warner by AT&T is one of the most important deals of the decade. It would create America’s sixth-largest firm by pre-tax profits, one that delivers internet and media services to hundreds of millions of people. It has become a political football after the Department of Justice indicated that it might block the deal or impose penal conditions. Some worry that the DoJ is being directed by President Donald Trump, who hates CNN, a news channel that Time Warner owns.

That the nominally independent antitrust apparatus is under a cloud is depressing. But revisiting the deal this week, a year after it was announced, Schumpeter was struck by another remarkable thing: how waffly AT&T’s rationale for it is. Over $100bn is being spent, based on vague reasoning and figures.

America’s media and telecoms industry has long had episodic deal frenzies, reflecting a combustible mix of technological change, juicy profits and ambitious moguls and managers. A long-standing dilemma is whether it makes sense to combine “pipe” companies that connect customers by mobile or fixed lines, and “content” firms that make and bundle packages of TV shows and web content. Most firms have been inconsistent and made several U-turns over the years, flitting between “vertical” integration (owning pipes and content) and horizontal scale (having a high market share in either one or the other).

Today there is disorder under heaven again, sparked by the rise of Netflix and Amazon Prime, and the media ambitions of other tech firms such as Apple. No one is sure how to react. Rupert Murdoch tried to bulk up in the traditional content business in 2014, by bidding for Time Warner, but has recently been in talks to exit it by selling his firm, 21st Century Fox, to Walt Disney. The talks are now reported to be inactive. T-Mobile and Sprint, two wireless operators that have had an interminable courtship, abandoned a proposed merger on November 4th.

Until a year ago AT&T was a rare model of consistency: it sought an oligopoly by buying other pipe firms. In some ways it succeeded. It has over 150m customers, equivalent to one in two Americans (Verizon, T-Mobile, Sprint and Comcast are the other big pipe firms). Weak competition means telecoms prices in America are at least 50% higher than in other rich countries. AT&T has a healthy return on capital of 17%, excluding goodwill.

Unfortunately, things are less impressive if you include the premium that AT&T has paid over book value to buy its empire. Including goodwill, its return on capital is a poor 9%. It extracts vast profits from its users but has given away much of the gains to the owners of the assets that it bought, not its own shareholders.

Enter the Time Warner bid, announced in October 2016. AT&T’s new goal is to be a vertically integrated firm that owns pipes and world-class content. Beyond that, its justification has been fluid. It has said that doing everything under one roof will make it more nimble at serving customers. This month Randall Stephenson, AT&T’s boss, put weight on how the combined firm could track what customers watch, using these data to sell advertising, as Facebook and Google do.

AT&T’s logic is weak in three ways. First, if you think the traditional media industry is about to be disrupted, why buy a traditional media firm? Perhaps half of Time Warner’s profits come not from making brilliant series such as “Game of Thrones”, or running clusters of creative excellence, such as HBO, but from a much grittier game of bundling TV shows into packages and selling them at ever more inflated prices to a dwindling number of cable TV customers. Over the past three years such price rises have boosted profits by about 14%—without them Time Warner would be almost stagnant. This is the bubbling earnings stream that Netflix and Silicon Valley firms are keen to divert.

Second, the numbers do not add up. At the offer price of $108 per share, AT&T will make a lowly return on capital of 5.5% on the deal. If it hits its cost-cutting targets, this will rise to about 6%. Even if you think the new firm will make the same advertising profits per customer as Facebook, the return would still be a subpar 8%.

AT&T could boost returns by using its muscle in the pipes business to force clients to buy Time Warner’s content rather than that of rivals. If Time Warner’s market share rose from 20% to 35%, the deal’s return would rise to a decent 11%. But this approach would run up against the third problem: regulation. Even if the deal is allowed, regulators would demand that AT&T ran Time Warner without discriminating against other pipe or content firms. This would make it harder for AT&T to extract benefits that other firms could not. A vertical deal between Comcast and NBCUniversal, in 2011, had similar conditions.

Curb your enthusiasm

Perhaps AT&T thinks that it can outwit regulators by agreeing to such terms and then dancing around them once the deal is completed. Plenty of powerful American firms manipulate their regulators. But there is another explanation: that AT&T cannot bear being a stagnant cash cow. Its compensation scheme is a licence to pursue bad deals. Executives are rewarded based on earnings-per-share growth, which can be flattered by largely debt-financed deals such as Time Warner. They are also measured against a return-on-capital hurdle, but at 7.25% this is almost negligently low. About 70% of firms in the S&P 500 index beat this yardstick. With a market value of $208bn, AT&T may be too large for disenchanted fund managers or activist funds to take on.

America’s antitrust regulators—assuming they are free of political interference—face a conundrum. The only way the deal appears to make financial sense is if AT&T abuses its position. For AT&T shareholders it is a dilemma, too. The company says it is prepared to fight the government in court. Shareholders should have a long, hard think about whether a protracted legal battle to complete a mega-deal with pedestrian returns is worth it.