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June 12, 2018

Naveen Khanna: AT&T’s Pyrrhic victory

Naveen Khanna is the A.J. Pasant Endowed Chair Professor and chairperson in the Department of Finance in the Eli Broad College of Business.

There has been much joy over Judge Leon’s approval of a nearly $80 billion acquisition of Time Warner by AT&T after a hard fought legal battle that lasted nearly a year and a half. Even though the judge was explicit that this is an AT&T-Time Warner specific ruling, firms like Comcast, Disney and Sprint are chomping at the bit to acquire firms that may have been beyond their pale.

Bankers for AT&T and Time Warner are likely to earn over $200 million from this decision (Dealogic) and hope to have a banner year from over $2 trillion worth of deals already in the works which now are considered more likely to get through. The other big winners are the take-over targets.

Not only have the market prices of Time Warner and 21st Century Fox reacted very positively, but also those of other potential targets like Sky, Lionsgate, CBS and others. It appears like an open season on media acquisitions.

However, to be the devil’s advocate, let us pause to answer two fundamental questions. First, are these acquisitions well-conceived acquisitions or ego-centric battles — even desperate gambles, frantically cheered along by astute bankers who stand to make hundreds of millions and desperate merger-arbitrage hedge funds hoping to recover from busted mega deals of previous years?

Second, why is a media company like Time Warner so eager to merge, and why is Rupert Murdoch apparently surprisingly anxious to off-load 21st Century Fox to Disney or potentially even to Comcast? Is it because they feel that such deals are likely to create significant amounts of synergy, or is it because an era of easy cash and cheap capital provides them a perfect timing to exit? A quick look at a few financials can help shed some light on both these questions.

If you look at the stock price performance of AT&T since the deal with Time Warner was first announced in October 2016, you’ll notice that its stock price peaked over $43 — just before the announcement. Around the announcement, it lost over 10 percent in market cap and has since zig-zagged all the way down to nearly $32 per share.

In just two days after the court decision, it lost over 5 percent in equity value. In total, it lost around $60 billion in market cap since the offer, or around 25 percent of its equity value. During the same period, Time Warner’s market cap rose from around $45 billion before the offer to over $75 billion. That suggests, the market believes AT&T is massively overpaying for Time Warner even after taking potential synergies into account. No surprise then that Time Warner has been so supportive of being taken over by AT&T.

A finer look at AT&T’s financial reveals that its EBIT, in fact, has been dropping for the last two years with a decrease of nearly 10 percent in 2017. When compared to one of its more successful competitors, Verizon, it is seriously under-performing. AT&T’s profit margin is only 6.8 percent compared to Verizon’s 11.6 percent, and its 5-year average earnings growth rate is 3.5 percent against 60 percent of Verizon’s.

When AT&T is getting so badly beaten on its home turf, how does it expect to make up by acquiring an asset like Time Warner which has wildly different business, culture and identity? AT&T is a top-down extremely hierarchical company dependent on its existing and tangible technology and established infrastructure.

Time Warner has a flat or even bottom-up organizational structure that is very dependent on an employee base which demands creative independence, freedom to experiment and reward even for failure. AT&T can handle employee turnover with reasonable ease, while if Time Warner loses its creative force, it has few tangible assets left of value.

It is doubtful such different cultures are likely to mesh enough for them to be able to develop synergies. If anything, this difference is likely to be a drag and value destroying as being suggested by the observed changes in market valuations.

Such hubris is a well-researched phenomena. Academic research has for the last three decades maintained that bidders overestimate the benefits of acquiring firms and thus on average overpay.

Bidder returns around acquisitions are, on average, negative while that of targets significantly positive. When aggregated together, the joint value of the two merging companies can be less that its parts.

Like in the AT&T example above, AT&T has lost $60 billion while Time Warner has gained $30 billion. That is a net social loss of $30 billion. Judge Leon would have done us all a favor by striking down this merger for reasons never brought before him or ones that he could have based his decision on.

It is not his responsibility to save AT&T from itself; the market and competition will take care of that in the future. Time Warner will likely be up for sale again, though, this time at a big discount from its current $85 billion acquisition price. Perhaps, too, AT&T.