By Eugene Timko, Investment Director of Finstar, for Medium.com
Telecoms has traditionally been one of the most profitable industries in the world. Its services are used by the vast majority of the populations of virtually every country; it is essentially impossible to find a country so undeveloped that it has a SIM card penetration of is less than 100% (in Moscow, for example, penetration exceeds 230%). It is extremely difficult for new players to enter the oligopolistic market created by existing operators in each geography. The investment in infrastructure that would be required to compete with existing operators would be colossal. For example, in the last five years, the US telecoms giant AT&T has spent $140 billion on the construction of its network. At the same time, the EBITDA margin of many operators is still around 40%. Despite this, however, telecom companies throughout the world have lost their direct connection with the source of this wealth, their customers.
Operators have in recent years been suffering from the Dumb Pipe Syndrome, in which consumers view telecoms operators as simply a conduit for data, and nothing more. The main value added comes from end users. Many online services that are parasitic to the infrastructure operators benefit from this model. It doesn’t matter, for instance, what kind of operator you have if your personal data are held with Google, Facebook, et al. Meantime, regulators all over the world are forcing operators to make certain changes – such as mobile number portability, which allows customers to change their operator without changing their number – that further depersonalize telecom providers.
For this reason, telecoms operators are increasingly looking to move closer to consumers. Realistically, they would probably admit that decades of rapid subscriber growth made their job easy. As a result, they do not have a reputation for innovation; most of their services have never reached any significant scale. Furthermore, every year, the operators have fewer opportunities to influence their consumers, and they have to pay high prices for experiments that have palpably non-obvious outcomes. However, telecoms companies have retained their financial muscle, and, as we have seen, they are ready for some serious spending. If Verizon distinguished itself by purchasing the moribund Yahoo, then AT&T immediately blew that away with its blockbuster deal to swallow Time Warner for $85 billion.
The deal to buy Time Warner, announced in October, is huge in every way – from the $300+ million investment banks garnered in the form of fees, to the scale of the combined company’s businesses. The purchase represents the merger of the largest telecoms operator in the US and one of the biggest media companies in the world. There are many reasons to suspect that such a mega-merger will be unsuccessful, from the now-hoary maxim that 80-90% M&A transactions fail, to the plight of the acquired asset. There is also, however, a strong basis for such a deal: the vertical integration of the two businesses could help both find new points of growth, become more stable and deploy their resources against the trends affecting both businesses.
In the race for value chain expansion, AT&T is following in the footsteps of its main competitor in the US, Verizon. But if the Verizon decided to play against Google and Facebook, trying to recreate an advertising empire from the fragments of once-strong assets – buying first AOL, then Yahoo – AT&T has more faith in old media, and is not bothering to chase the small fry. It’s almost as if it asked itself, “Why buy the once-largest online company, Yahoo, for the equivalent of a couple of small ‘unicorns’, and then haggle over price, when instead you can chase bigger prey and cut the deal of the year?”
However, the situation becomes more piquant due to the connection between Verizon, AOL and Time Warner. AOL bought Time Warner in winter 2000/01, and the deal was called the worst in history. It is now hard to imagine that the main channel for internet access was once terrible dial-up, and its pioneer in the US, AOL, could afford to purchase Time Warner for $164 billion. It represented a kind of culmination of the surrealism that pervaded markets at that time. When else could a company with revenues of less than $8 billion buy another with revenues of more than $30 billion? And AOL closed the deal at perhaps the worst time possible, the peak of the dotcom bubble and the beginning of the largescale transition to broadband (a market that AOL missed). It did not help that Time Warner executives, most of whom were against the deal, engaged in active sabotage.
Within a short time of the merger, AOL’s capitalization fell from a peak of $226 billion to $20 billion. It also suffered the biggest one-time write-off in history, $100 billion, in the two years after the transaction. By 2003, executives from Time Warner finally had AOL take the Time Warner name; six years later, Time Warner spun off AOL, allowing the company to float freely, which ended in Verizon’s purchase for $4.4 billion last year.
The idea of the current transaction with Time Warner is, as it was 15 years ago, to strengthen vertical integration through a merger of content and distribution. Getting access to content brands such as CNN, HBO, Warner Bros, DC Comics will undoubtedly strengthen AT&T’s offer to its more than 130 million customers. This strategy makes sense, but the tactics might be a problem. Several years ago, the largest provider of cable TV in the US, Comcast, bought NBC Universal for $30 billion (after a failed attempt to buy Disney), and the promised super synergies have failed to emerge. (Although, overall, it would probably be harsh to call the adventure a failure.)
Once, in the early 90’s, AT&T seriously considered buying Apple. We can imagine how that would have worked out – especially from the perspective of Apple’s chances of recreating the success it actually went on to achieve. But at the time, AT&T was looking for a vertical integration opportunity and new avenues of growth, and Apple appeared to offer that. However, the deal didn’t happen, and the mobile explosion did, which afforded AT&T two decades of growth anyway. Nowadays, operators are facing competition on all fronts in a saturated market, and once again, AT&T is looking for fresh pathways of growth. The company’s subscriber base has been falling – and the outflow accelerating – making the retention of customers a priority. But the operators have a secret weapon: the ability not to charge for data used accessing certain content providers (AT&T and Verizon already sells these packages to major media companies). And given the world is becoming increasingly mobile, and the content is trending toward video, Time Warner can get a significant advantage over other players in the AT&T network. On the other hand, the data transmission market is becoming more competitive overall (and there is Google, and Facebook, et al), and it is not clear to what extent will be AT&T able to realize this advantage.
AT&T’s purchase of Time Warner is therefore very much the standard response to the trends it faces, but it isn’t exactly an innovative or visionary one. Even though it was criticized for doing so, Microsoft’s $26 billion purchase of LinkedIn at least gave it a unique asset of unparalleled scope. Time Warner is actually struggling against the internet giants, which have finally realized the value of creating their own content. Netflix, Amazon, Google, and many others have succumbed to truism that content is the king, and are massively investing in content creation.
This is not a unique situation for Time Warner. The company has now been purchased three times, all of which were among the five largest technology deals in history. And if the transaction does not take place – there is a risk that it will be interrupted by Trump or the regulator – Time Warner could even come out smelling of roses, as AT&T would have to pay $500 million in compensation. (I note, though, that for a giant like AT&T, $500 million is not a huge amount; in 2010, when it failed in its attempt to buy T-Mobile, for $39 billion, it was forced to pay $4 billion, the largest compensation in history.)
Apple was also interested in buying Time Warner. In fact, for Apple, it would have made sense. If anybody could break the hegemony of Netflix in the US, it would have been just such a combination. However, people have long ceased to think of telecoms network providers as companies that provide good mobile services; the operator-subscriber relationship is largely confined to billing – and the last impressions people have is of not being able to get a connection at a crucial moment or the last invoice they received. Apple would have been another matter entirely.
Of course, without Jobs, it appears that Apple is increasingly lagging its competition, and its leader, Tim Cook, is starting to be compared with (the worst CEO in history) Steve Ballmer, who managed Microsoft for 13 years. But Cook has something that nobody else in the world of business has: almost a quarter of a trillion dollars. Moreover, the company has already demonstrated its willingness to make a serious bet on content, from the new Apple employee, Dr. Dre, making the first movie series for the company, to exclusive Rihanna and Drake shows on Apple Music this year. It would have seriously affected the balance of the online video segment had Apple gained access to Time Warner movies and TV series such as Game of Thrones to add to its music distribution muscle.
I believe that AT&T would actually have been better to have bought Netflix. The traffic of the popular online movie pioneer during peak hours reaches one-third of all US traffic, and puts plenty of pressure on AT&T’s network. Netflix could probably be purchased for a comparable amount to Time Warner, $60-70 billion. And the Netflix founder and CEO, the talented Reed Hastings, would be a valuable addition to the merged company. But now, if someone buys Netflix, it will probably be Time Warner’s main competitor, Disney, which has already announced such plans.
Telecoms across the world have been considering diversification for a long time. Much of the recent decade has seen them focused on expanding their product lines, with the main idea being a move toward triple play (communication + internet + TV). In some cases, this has already resulted in megadeals, including last year AT&T’s purchase of the satellite broadcaster DirecTV for $49 billion. However, what are telecoms operators to do when they reach the end of ‘classic’ services and products? It seems that mostly operators do not have a clue.
Their attempts to diversify through setting up various consumer services of dubious quality have not yielded results. The appeal of fancy consumer services – from taxi hailing and food delivery to provisioning of telehealth and financial services – is great. But these services are in many cases are loss-making for years (if not decades), which is at odds with the quarterly targets of publicly listed operators. For instance, aside from Safaricom’s M-Pesa, almost no operator succeeded in mobile payments, despite many attempts and the natural fit into the segment. And now the field is being divided by new entrants ranging from retailers to banks and, yes, to many internet and tech giants.
However, it is possible that this year, with its megadeals, that telecom operators will reach a turning point. And if the content is a return to the old strategies, many operators are finally beginning to recognize the importance of creating completely new verticals within their businesses. Operators see segments with a high proportion of start-ups, or sectors like fintech, as the new growth points. While innovation has not traditionally come easy to telecoms, they are not going anywhere soon. And 2016 might yet be the harbinger of a new strategy for telecoms, when they are bold enough to experiment and take decisive steps.