The AT&T/Time Warner merger announcement: a primer for contract attorneys

By:

Gregory P. Bufithis, Esq.
Eric De Grasse
Catarina Conti

NOTE TO CONTRACT ATTORNEYS: on the “big side”, Sullivan & Cromwell is advising AT&T and Cravath Swaine & Moore is advising Time Warner Inc on the deal. Early word from a contact at Sullivan is the antitrust scrutiny will be monumental given it is in the media and telecommunications space. Arnold & Porter is handling regulatory/e-discovery issues for AT&T. Cravath is doing the same for Time Warner side.  It appears Hire Counsel is staffing the e-discovery review for the AT&T side, and Compliance is staffing for the Time Warner side. But this information was secured through law firm staff attorneys and we are still trying to confirm.

25 October 2016 – In the world of media, bigger remains better.

So in the wake of Comcast’s $30 billion takeover of NBCUniversal and Verizon Communications’ serial acquisitions of the Huffington Post and Yahoo, AT&T has bought one of the remaining crown jewels of the entertainment industry.

This past weekend the telecommunications giant agreed to buy Time Warner, the home of HBO and CNN, for about $85.4 billion, creating a new colossus capable of both producing content and distributing it to millions with wireless phones, broadband subscriptions and satellite TV connections.

The proposed deal is likely to spur yet more consolidation among media companies, which have already looked to partners to get bigger. This year, Lionsgate struck a deal to buy the pay-TV channel Starz for $4.4 billion. And the Redstone family, which controls both CBS and Viacom, has urged the corporate siblings, which split 10 years ago, to consider reuniting.

AT&T and Time Warner said both of their boards unanimously approved the deal.

Understanding the market reasons and the antitrust implications

Most analysts and investors have noted that Time Warner was part of one of the biggest merger follies of all time, when it sold itself to AOL at the height of the dot-com boom. That combination — also pitched on the idea of uniting content and the internet — proved unwieldy and was later stripped apart to a few core businesses.

And many are saying this is AT&T/T-Mobile all over again. There was certainly a valid antitrust criticism of AT&T’s attempted acquisition of T-Mobile: both companies were mobile telecom providers, and their combination would have reduced competition in the U.S. mobile telecom industry, which would certainly mean fewer choices and likely higher prices. That’s not really the case in this proposed acquisition, though: AT&T and Time Warner don’t really compete in any meaningful way. The far more appropriate precedent for this deal is Comcast’s acquisition of NBC Universal, a deal that was approved by regulators ahead of schedule.

Indeed, it is the apparent lack of connection between the two companies’ business models that is driving the deserved skepticism of this deal: you can argue that this acquisition makes synergistic sense and that it raises antitrust concerns, but you can’t say the deal makes no sense and is also an antitrust violation. The entire reason we have antitrust laws is because there are strong market forces driving monopolistic behavior.

The AT&T perspective

So what exactly is AT&T (and Time Warner) thinking? From our perspective the telecoms giant has three problems that are (potentially) addressed by this deal.

First, AT&T is the preeminent income stock and a 32-year member of the Dividend Aristocrats — S&P500 companies that have increased their dividend for 25 straight years or more — and its attractive dividend yields are one of the most compelling reasons to own the stock. Those increases, though, have been minuscule for years, and even then have threatened to outpace AT&T’s free cash flow (reducing what is known as AT&T’s “dividend coverage”). AT&T’s acquisition of DirecTV a year ago helped a lot in this regard — it was arguably the chief reason for acquiring a company in secular decline — by virtue of being accretive to earnings-per-share and more importantly free cash flow. Acquiring Time Warner does the same: the acquisition is expected to be accretive to both earnings-per-share and free cash flow, buttressing and maybe even accelerating growth in AT&T’s dividend and, by extension, its stock price (I told you this reasoning was less sexy than movie stars!).

Secondly, AT&T’s core wireless business is competing in a saturated market with few growth prospects. Apple’s gift to the wireless industry of customers demanding high-priced data plans has largely run its course, with AT&T perhaps the biggest winner: the company acquired significant market share even as it increased its average revenue per user for nearly a decade, primarily thanks to the iPhone. Now, though, most everyone has a smartphone and, more pertinently, a data plan. Time Warner, meanwhile, has both growth and growth prospects; in other words, this is a diversification strategy.

Third, the implication of a saturated market is that growth is increasingly zero sum, which presents both a problem and an opportunity for AT&T. The problem is primarily T-Mobile: fueled by the massive break-up fee paid by AT&T for the aforementioned failed acquisition, T-Mobile has embarked on an all-out assault against the incumbent wireless carriers, and AT&T has felt the pain the most, recording a negative net change in postpaid wireless customers for eight straight quarters. Unable or unwilling to compete with T-Mobile on price, AT&T needs a differentiator, ideally one that will not only forestall losses but actually lead to gains.

At first glance this doesn’t explain the Time Warner acquisition either: per our point above these are two very different companies with two very different strategic views of content. A distributor in a zero-sum competition for subscribers (like AT&T) has a vertical business model: ideally there should be services and content that are exclusive to the distributor, thus securing customers. Time Warner, though, is a content company, which means it has a horizontal business model: content is made once and then monetized across the broadest set of potential customers possible, taking advantage of content’s zero marginal cost. The assumption of this sort of horizontal business model underlay Time Warner’s valuation; to suddenly make Time Warner’s content exclusive to AT&T would be massively value destructive (this is a reality often missed by suggestions that Apple, for example, should acquire content companies to differentiate its hardware).

The Time Warner perspective

What should worry AT&T’s shareholders is the extent to which this deal looks like a massive win for Time Warner (and to my just-made point, Time Warner’s break-up fee is a significantly larger $1.7 billion).

First, AT&T’s purchase price of $107.50/share is a big jump over the $85/share offer from 21st Century Fox back in 2014, despite the fact cable-centric media companies in particular look much less attractive today then they did two years ago. Indeed, whatever benefits may accrue to AT&T’s wireless business must be set aside potential losses from decreased cable penetration (although Time Warner is more shielded against so-called “skinny” bundles than is Disney; channels like TNT must be available on 90% of cable bundles, while ESPN negotiated its guaranteed availability to 80% in exchange for big rate increases). Time Warner’s movie business is also threatened by the explosion in attention-devouring alternatives, and it’s not clear how AT&T improves the long-run outlook.

One part of Time Warner that could benefit is HBO: AT&T has a billing relationship with nearly 130 million U.S. customers, and the premium network is particularly attractive to the sort of users that AT&T may be increasingly unable to reach with its TV business. HBO is also a natural fit with the zero-rating potential we discussed above.

Big picture, though, there’s a reason Time Warner used to be not just video but also magazines (Time Inc.) and music (Warner Music group): there are synergies between all types of media both in terms of creation and in business model. Time Warner, though, spun off those businesses because the Internet obsoleted the physical distribution mechanisms that led to monetization (CDs and paper), and, in the case of the former, introduced new advertising opportunities that were superior to topic-based segmentation. Video has held up both because it is still expensive to compete with great content and because huge swathes of the economy are invested in the ecosystem surrounding TV and advertising. The long-run trends, though, are not in Time Warner’s favor, and shareholders should be pleased to get out at such an attractive price.

Indeed, this deal is in many respects the exact opposite to that other famous deal involving Time Warner: its acquisition by AOL during the height of the dot-com bubble. In that case it was the distributor — AOL — that had a business model trending towards obsoletion. AT&T, in contrast, will make a lot of money for a good long time selling data in particular; in fact, the company is an enabler of the exact trends that threaten both Time Warner and DirecTV. What is concerning about these acquisitions, then, is not “higher prices and fewer choices for the American people,” but rather the exact opposite: that AT&T will decrease prices and increase choices when it comes to accessing its content, effectively burning down the bridge it itself built, leaving the truly open Internet a casualty.

As a side note, if you want to get really radical, one could argue that infrastructure providers integrating into content should be combined with local loop unbundling — opening up said infrastructure to competing data providers. This approach uses competition instead of regulation to guarantee an open Internet (and lower prices); sadly, it’s unlikely to be the reality in the United States anytime soon, even if AT&T and Verison’s diversification suggest they see increasingly less return from a focus on improving infrastructure (incentivizing the pursuit of this sort of return is one of the arguments against local loop unbundling).

Still, there is one similarity to that disastrous deal, at least in broad strokes: AOL pulled off that 2000 acquisition by virtue of its dot-com inflated stock price; AT&T, meanwhile, can countenance increasing its already massive debt load thanks to unprecedented low interest rates (which also help AT&T’s stock — that dividend yield is that much more attractive in today’s environment). A change in the environment could make this already dicey-looking deal a downright bad one.

Some other analysis

First off, many have questioned why Time Warner would divest Time Warner Cable (another distributor) only to tie up with AT&T. A few points on that:

• First, the primary actor is different; the Time Warner Cable spin-off was initiated by Time Warner and it made sense for all of the reasons it makes sense to not combine horizontal and vertical businesses that have very different strategies, capital structures, and regulatory environments. This tie-up, on the other hand, is initiated by AT&T, and Time Warner is getting a great deal; if management believes the price AT&T is willing to pay is higher than Time Warner is worth as a standalone company, then they have a fiduciary duty to accept the offer, even if they think AT&T’s strategy isn’t the optimal one.
• Second, Time Warner Cable is (mostly) a monopoly provider for TV and wired Internet access (there is nominal competition in some markets from telecom providers). AT&T’s primary business, on the other hand, is wireless, which does operate in a (more) competitive environment; this expands the potential strategic benefits from vertically integrating.
• Third, AT&T, thanks to its DirecTV acquisition and (much smaller) U-Verse service is now the number one paid-TV provider in the country, meaning AT&T can both think much more strategically about how Time Warner prices its cable content and more viably leverage said pricing in negotiations with other content providers (setting baselines, etc.).

Secondly, you’ll see much discussion about “zero rating”.  Zero-rating (also called toll-free data or sponsored data) is the practice of mobile network operators (MNO), mobile virtual network operators (MVNO), and Internet service providers (ISP) not to charge end customers for data used by specific applications or internet services through their network, in limited or metered data plans. It allows customers to use provider-selected content sources or data services like an app store, without worrying about bill shocks, which could otherwise occur if the same data was normally charged according to their data plans and volume caps. This has especially become an option to market 4G networks, but has also been used in the past for SMS or other content services.

In combination with zero-rating some services, MNOs are typically setting relatively low volume caps for open internet traffic or conversely, over-pricing open internet data volumes. Choosing to zero-rate existing third-party services trending among an attractive audience for the mobile network operator allows the MNO to increase or defend its market share for the target segment. This price discrimination works also in favor of the chosen third party service.

Building their own services and delivering them at a zero-rate if bundled with their mobile contracts has also been a common practice among mobile operators. In this scenario, network operators can optimize their service together with their network to deliver an optimal service. Together with the existing billing relationship, this can be an important factor to compete with third party services or take control over volume-heavy services.

Now, applying all that to the AT&T/Time Warner deal:

• Yes, AT&T can zero rate any data that they wish; T-Mobile is currently doing just that. Many telecom analysts are not in favor of this (see below), but as a strategic matter it’s an approach that is available to any distributor. Note, though, that T-Mobile is “paying” for zero-rating out of its own pocket.
• In the case of DirecTV AT&T is “charging” DirecTV for zero rating; of course that is simply shifting money from one pocket to the other, but it means that AT&T can charge competing content providers to also be zero rated, which is exactly what they are doing.
• AT&T can do the same thing with Time Warner content: HBO, for example, could be zero rated on AT&T; if Netflix wants to also be zero rated they need to pay up, and if they refuse, AT&T has a reason for customers to switch to their wireless service. They benefit either way in a way that T-Mobile, for example, cannot.

Ben Thompson, a key media analyst, laid out the pros/cons in an article back in 2014, entitled Netflix and Net Neutrality. Briefly, while zero rating does not mean treating different data differently, it does mean that incumbents who can afford to pay have the advantage over new entrants; given my belief that the Internet enables new kinds of businesses that will be critical to address the massive disruption that is happening, that’s a really big problem, which is why I am quite resolute in my opposition to the discriminatory treatment of data in terms of both speed and price.

Note that article recognizes the equally important need to incentivize infrastructure investment, which is why Thompson is pro-metering: insisting on both unlimited data and net neutrality (and no zero rating) means no incentives for infrastructure investment, an economic reality that is far too easily dismissed by advocates who want to have their cake and eat it too.

And a “biggie” for analyzing this deal: last week the FCC’s auction of recovered TV spectrum failed for the second time due to lack of interest. Apparently AT&T believes it is better to spend their money on Time Warner than on spectrum, which ought to be concerning to anyone who cares about the long run.

What does this deal mean for consumers?

A key concern is whether the newly merged company might use its huge distribution network (the customers of DirecTV and its wireless and broadband services) to give an unfair advantage to its own content, delivering it in a way that is faster or more accessible than competitor content. This would, of course, violate the principle of net neutrality, whereby internet service providers should not favor or block any particular products or websites.

AT&T has form for this. It already offers AT&T wireless customers the ability to watch DirecTV without it counting against their data plan. This “zero-rating” strategy (described above) means it’s cheaper to stream DirecTV than it is to use other services. Following the Time Warner deal, AT&T could extend this zero rating to Game of Thrones, Harry Potter movies or NFL football on TNT. That’s good news for AT&T customers but could be seen to give its own service an unfair advantage over competitors such as Dish Network’s Sling TV or on-demand services such as Netflix and Hulu, unless they pay AT&T to have their own zero-rating deal.

Whether it’s channel position or recommendations on your home screen, the distributor certainly has the technical capability to give their own content more visibility than their competitors if they are left to do so.

The end result is that it becomes harder for other content providers to compete for end users’ attention. In the long run this could mean less competition altogether, which could lead to higher prices.

And as you might expect, not everyone agrees. In reality, regulatory constraints mean that it is almost impossible to use vertically owned content to the advantage of distribution, and it is equally impossible to use captive distribution to the advantage of vertically owned content.

A less clunky experience between devices

This type of deal should allow AT&T to create a better user experience as they access content across multiple devices, whether that’s their cellphone, tablet or TV – an experience that has traditionally been clunky and painful for users.

They can connect the dots as the content flows from the big screen to the laptop to smartphone or tablet. AT&T will be able to data mine a person’s location, devices and behavior in order to provide the right content at the right time in a more efficient way. It makes for a more holistic user experience that could lead to consumer-friendly innovations.

More targeted advertising

Like it or not, advertising helps fund most of the content we consume. The merger of AT&T and Time Warner could mean more granularity to ad targeting. AT&T has already launched addressable TV advertising, where different households watching the same program will see different commercials, through DirecTV. This approach could be extended throughout all of the new company’s offerings and across platforms.

I know ads are painful to watch sometimes, but it’s necessary because it pays the bills. More contextual advertising means the doctor might get the ad for Mercedes or BMW while the child might see Pepsi, Coca-Cola or video game ads.