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Are megamedia mergers doomed at the altar?

Old media, new media--forget all the buzzwords. There's a more important principle the heads of big media should consider before consenting to blockbuster marriages, according to Wharton experts.

8 min read
It's now AOL Time Warner's turn to take center stage as the latest poster child of America?s megacorporate meltdown.

Last week, on the day the world's largest megamedia company posted its first quarterly net profit since completing its megamerger, the Securities and Exchange Commission announced it was investigating AOL Time Warner for questionable bookkeeping--joining the likes of Enron, WorldCom, Tyco and Adelphia. The SEC investigation was initiated in response to articles in The Washington Post that suggested AOL might have inflated its revenue over a two-year period ending in March.

The week before, new CEO Richard Parsons accepted the resignation of former MTV and AOL wunderkind Robert Pittman, the company?s chief operating officer. Parsons reorganized the executive suite, elevating two respected Time Warner executives, Don Logan, CEO of the Time magazine publishing unit, and Jeffrey Bewkes, CEO of Home Box Office. At one point, Pittman had been considered heir to the CEO throne, and there is some speculation he could land at another megamedia giant, such as Disney.

Since AOL and Time Warner completed its merger in January 2001, the value of its stock has declined by more than 75 percent. When news of the SEC investigation broke last week, the price dropped to $9.51, a one-day decline of 15 percent, but has since climbed back above $11. At the height of the Internet boom, America Online used its soaring stock to acquire Time Warner, an old-media company with four times its revenue. Recently, however, some investors and analysts, among others, have targeted Steve Case, the company?s chairman and architect of the $165 billion merger, for removal.

"De-merging would be a solution. They have to look at (themselves) and ask, 'Are we still a compelling business model for ad agencies to reach people??"
--Gerald Faulhaber, Wharton professor of business and public policy

So what?s ahead for AOL Time Warner?

"De-merging would be a solution," says Gerald Faulhaber, Wharton professor of business and public policy, and an early critic of the AOL Time Warner merger. "They have to look at (themselves) and ask, ?Are we still a compelling business model for ad agencies to reach people??"

The merger, Faulhaber adds, has been a "big distraction, not for Time Warner, but for AOL because they lost their focus." The only potentially positive aspect in the deal was that AOL would get "access to broadband conduit?and that was unsuccessful." Furthermore, the merger's dysfunction has been intensified by bitter infighting and a culture clash between AOL and Time Warner divisions and people.

"AOL Time Warner is clearly not going to survive," says Wharton marketing professor Jehoshua Eliashberg. "It is really about different cultures clashing. Pittman had to resign. It was like trying to mix oil and water. The way AOL and Time Warner (each) think about business is different."

While AOL Time Warner once talked of magical synergies between the "new media" and "old media" and between "content" and "delivery," now many in the business press are openly speculating on when the company will split up. That may indeed be the fate of Vivendi Universal after its meltdown under controversial CEO Jean-Marie Messier, who was forced out several weeks ago.

"Old media" prevails: Synergy fizzles
Whatever the future holds for companies like AOL Time Warner--which may decide to sell or spin off AOL in the future--and Vivendi--which is looking post-Messier to sell large units to raise cash to pay down debt--the megamedia companies are under extreme duress.

As recently as July 28, Thomas Middelhoff, CEO of global media conglomerate Bertelsmann of Germany, was fired after an apparent fight with the company?s controlling shareholders over company strategy. Bertelsmann owns interests in publishing, television and music. Its holdings in the U.S. include Random House, Bertelsmann Music Group, Napster and several magazines.

"You are a CEO with a big ego and you say 'synergy, synergy, synergy' to your board of directors, and they say 'yes.'"
-- Jehoshua Eliashberg, Wharton marketing professor
The recent changes make one thing clear: Old media rules, for now. "Synergy" might have been the buzzword for press releases two years ago, but today it?s a business concept that should be used sparingly. "I?ve been a skeptic from the beginning about the AOL and Time Warner merger," says marketing professor Peter Fader. "In the long run it?s brilliant," but the cross-fertilization they were betting on won?t occur until the next generation, in other words, "when today?s kids who are six and seven become adults and broadband is ubiquitous.

"Ultimately the marriage of content and delivery is a good one," he suggests. AOL and Time Warner had a workable idea, just very bad timing. "They should break up as quickly as possible. Maybe they should consider merging again in about 15 years, if AOL is still around." Although AOL is huge, "nobody looks at the company and says, 'Wow, that?s tech done right.' They say, 'That's tech for idiots,' and our kids will want a lot more." Two years ago, he added, "people viewed AOL as the go-go growth business, even though it had already saturated most of its market potential. It was clear that AOL?s growth would be leveling off."

According to Faulhaber, AOL lost its focus because it mistakenly was trying to "force feed" AOL and Time Warner content. "AOL is not about pushing content down the pipe; it's about peer-to-peer. It?s community. The Internet is about peer-to-peer, not TV. The Internet is an inferior distribution channel for content, much inferior to cable and satellite." As for broadband, Faulhaber adds, "People talk about broadband and a 'killer app.' That's absolutely wrong. The notion it will be the equivalent to movies is wrong. It's not one-to-many. It's one-to-one."

In its second quarter 2002 financials released last week, the company reported that all Time Warner divisions posted second-quarter results that met or exceeded expectations. Overall, second-quarter revenue rose 10 percent, to $10.6 billion, from the period a year earlier, and its cash flow, or earnings before interest, taxes, amortization and depreciation, rose 2 percent, to $2.5 billion. Its film and television studios and networks performed particularly well with the film-entertainment division reporting a 31 percent increase in cash flow on a 26 percent increase in revenue. Brisk sales of home videos such as "Harry Potter and the Sorcerer?s Stone" and box-office hits like "The Lord of the Rings" helped.

Parsons told the business media last week that he stands by the company?s projections for a single-digit percentage increase in third-quarter revenue, and flat or modestly declining cash flow. For the full year, Parson says AOL Time Warner expects revenue to increase nearly 8 percent, at the high end of its previous projections.

Overall, however, results were dragged down by the performance of America Online, whose revitalization Parsons called his "top priority." AOL's revenue fell 3 percent, and its cash flow fell 27 percent from the previous year. The Internet company reported a 31 percent decline in its business to $501 million. Advertising revenue fell more than 40 percent, with few signs of a recovery anytime soon.

Additionally, the online service only added 492,000 subscribers, less than half as many new subscribers as in the quarter the previous year. Its share of the online market in the United States has slipped to 37 percent from 41 percent two years ago. And the company is lagging in broadband with less than 5 percent of the market. Today in the U.S. about 13 million of the 60 million households with Internet access have high-speed, broadband connections. The adoption of broadband by consumers, and AOL?s slow growth in it, is providing openings for its rivals, including Microsoft, Yahoo and telephone and cable companies.

"The investigation into AOL's accounting and the dramatic decrease in the growth of new subscribers at AOL" are two big causes for concern.
--Jordan Rohan, Soundview Technologies analyst
Some analysts say the SEC investigation and America Online's weakness overshadow Parsons' reassuring comments. "The investigation into AOL's accounting and the dramatic decrease in the growth of new subscribers at AOL" are two big causes for concern, Jordan Rohan, an analyst at Soundview Technologies, told The Washington Post.

Megamergers: Some unlikely partners?
Given these developments, what could happen with the AOL part of AOL Time Warner? "It could be spun off in an LBO (leveraged buyout)," said marketing professor David Schmittlein. "Certainly it would be hard to imagine that someone else would buy it. It?s a tough market to sell into. If Time Warner is selling AOL it would be as a fixer upper."

While it?s hard to imagine the world?s largest online service--with 34 million dial-up customers--as a fixer upper, perhaps that's the most likely solution, one that would make sense long-range. In the meantime, who knows what megamedia companies will emerge in the next generation, possibly from the unlikeliest sources.

Take, for example, General Motors and Microsoft.

"If someone proposed a merger between Microsoft and GM, people would say that's absurd," Fader said. "But in 15 to 20 years, a lot of computing that people do will be done in their cars, which will be actively computerized. So it will be a natural match, but it seems so far from anything on the radar screen right now. People should view AOL and Time Warner in the same way."

Today?s megamedia companies--AOL Time Warner, Viacom, Vivendi, Disney, Bertelsmann, Sony--may not be tomorrow?s. While they all became behemoths because of past mergers among big media companies, it?s very likely some of them will change into different entities, perhaps with some unusual partners.

"The megamedia companies that exist today," says Schmittlein, "only exist because of previous megamergers. There have been tons of media mergers and buyouts cutting across all kinds of businesses, from content providers to delivery, and they have not been successful. There has been a substantial inclination to merge among content providers, like movie studios and music. It is only when content providers and media vehicles merge that there has been a real problem. The efficiencies or revenue opportunities have underwhelmed."

Faulhaber says he has always been a "skeptic of mergers of media and media, and certainly of distribution channels and content. I think the Time Warner merger with Turner is a good case in point. Time Warner got some great cable properties with great possible synergies between content and cable, but these guys just have never demonstrated they know what to do with it. Time Warner has messed it up. I don?t think Time Warner gained anything."

So what does the future hold for megamedia companies? Comments Schmittlein: "How are people going to get high-speed Internet access? Who will provide it? Who will provide the opportunities to marry media and content? Is it the cable companies? The telephone company? We don?t know yet who that will exactly be. AOL?s bet is that there is a lot of inertia among consumers and a disinclination to abandon AOL?s service for a new provider."

According to Eliashberg, the megamedia merger trend "was a mirage. Some of this was driven by ego. You are a CEO with a big ego and you say 'synergy, synergy, synergy' to your board of directors, and they say 'yes.' That?s an ego-driven acquisition, and ego-driven acquisitions are not good business. You can?t decide to acquire another business if it?s only remotely related to your core competency."

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All materials copyright © 2002 of the Wharton School of the University of Pennsylvania.