Create and answer a case study similar to Memo 8 from Time Warner (Most Relevant Chapters 3, 5, 7, and 13) that looks at complementarities and vertical integration Kwin Raymer
MEMO 8
To: Strategy Group
From: COO
Re: Ramifications of AOL Divesture
I need your immediate input regarding the potential impact on our bottom line of selling our AOL unit. For obvious reasons, it is imperative that you treat this request as confidential. INTRODUCTION . In January 2000, the Internet pioneer, America Online, agreed to buy Time Warner for $165 billion in what would become the biggest merger in history. Time Warner was considered the largest traditional media company, and the merger served as evidence that old and new media were beginning to converge.
“The merger of AOL and Time Warner involved a vertical combination of the largest Internet content provider and aggregator and a large cable system operator which offered a conduit through which broad-band customers could access Internet content at high speeds.” 1
AOL’s nearly 30 million paying customers worldwide were positioned to gain access to Time Warner's entertainment and information empire and were also positioned to potentially switch from using modems and telephone lines to go online to accessing the Internet via Time Warner's cable television systems. Those cable systems, which served 13 million subscribers at the time, would have enabled AOL to start offering much faster Internet and interactive television services. It is worthy of note that until this deal was stuck, no major cable company would carry AOL services.2 At the time of the merger, demand for dial up services was still very strong as broadband services had yet to gain significant market penetration. . BACKGROUND . Business Perspective
From a business perspective, the merger marked the blending of traditional and new media to exploit the opportunities offered by each entity; seemingly, the union made sense for both AOL and Time Warner. Between the two organizations, all of the integral components were in place to achieve success in the internet business - a strong customer base, appealing content, and proven distribution methods.
AOL was a successful and established gateway to the internet that was somewhat lacking in original content while Time Warner held a wealth of material in the form of news, films and cartoons but lacked the internet presence or know-how to distribute it effectively. AOL was in the position to use its well-established brand on the web as well as its proven strategies of using the internet to provide information and entertainment.” 3 . Economics Perspective . From an economic perspective, the primary advantages that AOL and Time Warner sought to gain from the merger related to complementary services and vertical integration. Michael Baye defines complements as “goods for which an increase (decrease) in the price of one good leads to a decrease in the demand for the other good.” 4 “Economic complementarity occurs when some inputs are used together within consumption/production bundles and some additional utility/output are generated by the bundles, other than the individual inputs.” 5 Opportunities abounded for the bundling of services including having AOL subscribers potentially retain exclusive rights to view the online versions of Time Warner content.
In the case of AOL and Time Warner, complementary products include the internet connectivity of AOL and the content of Time Warner. By merging, complementary firms have the opportunity to reduce their pricing externality and become more aggressive competitors when compared to substitute firms. The post-merger reductions in price should serve to both harm competitors and benefits consumers. However, for insiders, the shape of the demand curve will determine the profitability of the merger. 6 Baye defines vertical integration as “a situation where a firm produces the inputs required to make its final product”. 4 The benefits of vertical integration include improving supply chain coordination, providing more opportunities to differentiate by means of increased control over inputs, capturing upstream or downstream profit margins, increasing entry barriers to potential competitors, gaining access to downstream distribution channels, facilitating investment in highly specialized assets in which upstream or downstream players may be reluctant to invest, and expanding core competencies.7 For this merger, vertical integration was represented by the fact that the combined company could both produce content and deliver it via various channels.
Time Warner also stood to take advantage of the powerful network that AOL had built in terms of subscribers. This powerful network consisting of nearly 30 million worldwide subscribers was a captive market that was well-positioned to receive Time Warner content via the Internet. Though AOL subscribers used the AOL service as a method of accessing the Internet, they also stood to gain additional value from the network complementaries that would arise when Time Warner provided them with new content via the AOL interface. . REASONS FOR FAILURE . By most accounts, economic factors were not to blame for the failure of the AOL-Time Warner merger; instead, the failure to take advantage of the benefits of complements and vertical integration are largely considered the source of blame. For example, the large combined company never was able to adequately find a way to distribute the Time Warner content via AOL’s interface. While attempting to implement these pre-merger objectives, the company missed out on the changing landscape of the Internet industry. A particularly difficult blow to the company was AOL’s loss of dial-up subscribers who left for broadband options. This massive loss of subscribers diminished one of AOL’s primary assets—subscribers. At the same time, the company was unable to capitalize on other new industry trends such as music downloading and social media. “Even though there was hope for a complete integration of the companies and the ability of both companies to leverage the others’ strengths, this never materialized.”8 Internal clashes of corporate cultures is another oft-mentioned reason that the two entities were not able to take advantage of opportunities. . DIVESTING . “If firms want their strategic business units to supply or buy from each other, they should frequently reexamine their premises for such arrangements, because the strategic window that favored vertical integration can close.” Furthermore, “firms can act early and purposefully to lower exit barriers by limiting the degree, stages, and percentage of ownership that characterize their vertical relationships. Strategists must scan the effects of vertical integration on strategic flexibility just as they scan other forces that erect exit barriers.” 9
The same lack of integration that caused the merger to fail would also allow for the firms to split with a relatively minimal impact on Time Warner. AOL’s contribution revenues and intersegment revenues were the smallest within Time Warner in 2008. In addition, the contribution of AOL to Time Warner revenues (in both total and as a percent of contribution) was declining for several years. As such, spinning off AOL should limit Time Warner’s losses to the losses of future advertising revenue and to a lesser extent, subscription revenue.
. THE NUMBERS .
12
. POST-MERGER UPDATE: . Since splitting from Time Warner, AOL has been struggling to reinvent itself as a modern media company. Nearly ten years have passed since AOL was considered one of the most promising firms in the online realm. Today, its future appears uncertain as the former titan attempts to regain a position as a major Internet presence. In September 2009, J.P. Morgan valued the AOL at approximately $4 billion, a fraction of the $161 billion it was valued at when it acquired Time Warner in 2001. 10 . LESSONS LEARNED: . What lessons can be learned from one of the biggest failed mergers in history? While the merger may make economic sense on paper, it is also important to consider:
Shareholders from new companies and established companies have very different expectations. Keeping both groups of shareholders happy will be a challenge.
Similarly, the corporate cultures from a new tech company and an established traditional media company are likely to encounter difficulty. The differences in ages, styles and expectations among the two workforces were difficult to reconcile. 11
. CASE QUESTIONS: . 1. In economics, a complement refers to: a. Goods for which an increase (decrease) in the price of one good leads to an increase (decrease) in the demand for the other good. b. Goods for which an increase (decrease) in the price of one good leads to a decrease (increase) in the demand for the other good. c. The value of the output produced by the last unit of an input. d. A situation where a firm produces the inputs required to make its final product.
2. Which of the following was not commonly mentioned as a reason that this merger was not a success? a. Clashes of corporate cultures b. Lack of demand for internet services c. Inability to take advantage of complementary products and services d. None of the above
3. Declining demand of what AOL product or service lead to a sharp decrease in subscription revenue? a. Advertising b. News content c. Dial-up service d. Time Warner movies
4. From 2005 to 2008, what was the percentage change in AOL’s subscription revenue? a. +71.44 % b. -49.98 % c. -17.65 % d. -71.44 %
5. Excluding intersegment revenue, how much revenue (in millions) did AOL contribute to Time Warner in 2008? a. $8,090 b. $5,098 c. $4,165 d. $1,457
Answer Key:
b. Michael Bay defines a complement as a good for which an increase (decrease) in the price of one good leads to a decrease (increase) in the demand for the other good.
b. Demand for internet services remained high through the 2000s, however, AOL failed to take advantage of new industry trends.
c. While most consumers were switching to broadband services to access the internet, AOL was slow to promote broadband services in favor of their traditional dial-up service.
d. (1929-6755)/6755 = -71.44%
c. Per the Time Warner annual report, AOL contributed $4165 (in millions) to Time Warner in 2008.
SOURCES:
Rubinfeld, D. L., & Singer, H. J. (2001). VERTICAL FORECLOSURE IN BROADBAND ACCESS? Journal Of Industrial Economics, 49(3), 299.
MEDIA MEGADEAL: THE OVERVIEW; AMERICA ONLINE AGREES TO BUY TIME WARNER FOR $165 BILLION; MEDIA DEAL IS RICHEST MERGER By SAUL HANSELL Published: January 11, 2000, New York Times
Baye, M. R. (2010). Managerial economics and business strategy. New York: McGraw-Hill/Irwin.
Lee, J. (2008). Complementary Effects of Information Technology Investment on Firm Profitability: The Functional Forms of the Complementarities. Information Systems Management, 25(4), 364-371. doi:10.1080/10580530802384761
Anderson, S. P., Loertscher, S., & Schneider, Y. (2010). The ABC of complementary products mergers. Economics Letters, 106(3), 212-215. doi:10.1016/j.econlet.2009.11.022
SUMMARIES: Comparative advantage and trade (How do you determine your comparative advantage?) A comparative advantage in producing or selling a good is possessed by an individual or country if they experience the lowest opportunity cost in producing the good. Examples include Apple Corporation (marketing), Pakastani apparel (low cost), and Columbian illegal goods and services (drugs). There are a variety of reasons why individuals, firms, and countries gain a comparative advantage, and even more so, how it is determined a comparative advantage exists at all.
Concentration Ratios A concentration ratio is a measure of the total output produced in an industry by a given number of firms in the industry. Examples of concentration measures include Pivotal Supplier Index, Residual Supply Index, Four-Firm Concentration Ratio, Eight-Firm Concentration Ratio, Herfindahl-Hirschman Index, Rothschild Index, and the Lerner Index. As with all statistical data, concentration indexes should always be interpreted with caution as they have several potential limitations.
Economies of scale, diseconomies of scale, constant returns to scale, Efficiency in production Economies of scale exist when long-run average costs decline as output is increased. For example, larger companies are able to purchase input goods in higher quantity and benefit from discounts on the bulk orders. This results in lower average costs in the long run. Diseconomies of scale exist when long-run average costs rise as output is increased. For example, smaller companies can suffer from diseconomies of scale due to their lack of capital. Constant returns to scale exist when long-run average costs remain constant as output is increased. For example, in some industries average costs will scale in proportion with output. This can be achieved with the proper use of technology and software. Efficiency in production refers to the ability to produce a good using the fewest resources possible. Efficient production is achieved when a product is created at its lowest average costs. In order to gauge production efficiency managers can use three measures of productivity, total product, average product, and marginal product.
Market Failure When a market fails it is unable to provide the socially efficient quantities of goods. There are many reasons a market can fail including: anti-competitive market power, negative externalities, public goods, and rent seeking. A firm with market power has the ability to set its price above marginal cost. A monopoly is a good example of a market in which a firm produces less than a socially efficient level of output. The welfare that would have accrued to society if the industry were perfectly competitive but is not realized because of the market power the monopolist enjoys is the deadweight loss. Negative externalities are costs borne by parties who are not involved in the production or consumption of a good. The most common example of a negative externality is pollution. A public good is a good that is non-rival and non-exclusionary in consumption and is another way a market can fail. Rent seeking refers to self-motivated efforts aimed at influencing another party’s decision. Government policies generally benefit some parties at the expense of others.
Property Rights and Incentives Property rights refer to the ability to use one's properties in any manner that the owner chooses. Along with this utilization, an owner also exercises the ability to incur financial gains (or losses) based upon that usage. Tragedy of the commons refers to a situation in which a resource will eventually cease to exist or be usable. In the long term, this would be detrimental to the overall economy of the society which has destroyed this resource. When no private property rights exist and a resource is accessible to large groups, tragedy of the commons is likely to occur. Government monitoring, taxes, fees, fines, and implementation and enforcement of regulations are all ways to combat this. Week 6: The ABCs of complementary products mergers
The article above discusses issues related to mergers between firms of complementary products. Specifically, the article refers to the oligoply models that we are covering in class.
The article concludes that "By merging, complementary firms reduce their pricing externality and become more aggressive competitors vis-`a-vis substitute firms. This reduces prices and thus harms outsiders and benefits consumers. The shape of the demand curve determines whether a merger is profitable to insiders." Week 5:
What was the hope of the AOL-Time Warner Merger? Why do such big players want to merge? The merger marks the coming together of traditional and new media to exploit the opportunities offered by each. It makes overwhelming sense for both AOL and Time Warner.
Together they have the cocktail of ingredients to succeed in the internet business - a strong customer base, appealing content, and ways to distribute it.
AOL seeks to portray itself as a gateway to the internet, with its homepage as the starting point for exploring the web. But it lacks its own content to attract more users to the service.
As one of the world's leading media companies, Time Warner has a wealth of material, such as news, films and cartoons, that it could offer through the web. But it does not have the internet presence or know-how to do this effectively.
It has pumped millions into internet ventures but has failed so far to make an impact in cyberspace. What can both companies offer each other? Time Warner brings to the deal a whole raft of media interests.
It owns several cable television channels such as CNN, TNT, HBO and the Cartoon Network. It also publishes the magazine Time and People. And it has music and film interests, behind blockbusters such Blade, The Cell and The Matrix.
As the world's largest internet service, AOL brings more than 30m subscribers to the deal, as well as a well-established brand on the web. But more importantly, it brings tried and tested strategies of using the internet to provide information and entertainment.
This model suggests that mergers with bundling in systems markets could entail both pro-competitive and anti-competitive effects. In the event of any foreclosure of competitors, however, conglomerate mergers with mixed bundling would be predominantly anti-competitive. Even in the absence of such foreclosure effects, there is no clear-cut answer to how mixed bundling by the merging parties would affect consumer and social welfare. With heterogeneous consumer preferences, some buyers gain and others lose. For instance, those who previously purchased both products from the two merging firms would gain due to the lower bundle price. However, those who continue to purchase a mix-and-match system would suffer due to the increased stand-alone prices charged by the merged firm. As a result, the overall impact on consumer and social welfare is ambiguous.
In general, conglomerate mergers would have different implications for competition depending on specific market conditions such as market shares of the merging parties in their individual markets, economies of scale due to avoidable fixed costs, ease of entry, etc. To sort out pro-competitive effects and anti-competitive effects of each conglomerate merger case, the relative magnitudes of these countervailing effects and the likelihood of the foreclosure of one or more competitors need to be assessed. Blanket approvals of conglomerate mergers with the presumption that bundling is either pro-competitive or competitively neutral are certainly not warranted.
NEW YORK — AOL resumed life as an independent Internet company Thursday as it completed its spinoff from Time Warner Inc. and closed the book on one of the most disastrous business combinations in history. AOL shares fell 59 cents, or 2.5%, to $23.08 in midday trading.
Today's AOL is much different from the company once known as America Online, which got big in the 1990s by selling dial-up Internet access and then used $147 billion of its inflated stock to buy Time Warner. AOL, which is now worth about $2 billion, is trying to get most of its money from running advertisements on its portfolio of websites.
Those sites include the AOL.com home pages, Mapquest and tech blog Engadget. AOL isn't keeping the entertainment site TMZ, which is staying in Time Warner.
When AOL bought Time Warner in 2001, the companies bet that Time Warner's TV and magazine content would complement AOL's Internet business. Instead, broadband Internet connections began to kill off AOL's main source of revenue and drag down the whole company.
The company was once known as AOL Time Warner but dropped AOL from the name in 2003. That was a sign of what was to come: Time Warner announced AOL's spinoff last May after years of trying to integrate the two companies.
In a note to clients, BMO Capital Markets analyst Jeffrey Logsdon called the failed deal "a nine-year adventure akin to a marathon through the mud."
The new AOL has no debt. The company is profitable, though its operating income dropped 50% to $134 million in the third quarter from the same period a year earlier. Third-quarter revenue dropped 23% from last year to $777 million.
In the past year, AOL hired Tim Armstrong, 38, a former Google advertising executive, as CEO. Armstrong plans to cut up to 2,500 jobs, or more than a third of AOL's employees, on top of thousands of other cuts in recent years.
That will leave the company at less than a quarter the size it was at its peak in 2004.
The company plans to fill many of its websites with inexpensive material produced by freelancers paid by the post. This week it said it had hired New York Times reporter Saul Hansell to oversee part of that content-generation effort. Complement Definition A complement refers to a good or service that is used in conjunction with another good or service. Usually, the complementary good has little to no value when consumed alone but, when combined with another good or service, it adds to the overall value of the offering. Also, good tends to have more value when paired with a complement than it does by itself.
A product can be considered a complement when it shares a beneficial relationship with another product offering. In an economic sense, when the price of a good rises, the demand for its complement will fall because consumers don't want to use the complement alone.
For example, if the price of hot dogs rises so much that people stop consuming them, this will also cause a decrease in demand for hot dog buns. Because the price of hot dogs has an inverse relationship to the demand for hot dog buns, we call them complementary products. Week 3: Vertical Integration:
I guess that in the corporate world, there’s no easy way to do things. That it was a bad idea for Time Warner to buy AOL in 2000 was well known by most people, apart from Time Warner’s executives. They may have thought they were smarter than a fifth grader but instead got awful marks for their actions.
The funny part was that it was actually AOL that bought Time Warner, because the market value of the tech company was much higher than that of the venerable studio and publishing group. Time Warner was acquired by AOL for $182 billion, by putting up $166 billion of its overpriced stock for 55 percent of the combined company, (and not a single cent of “real” money). This despite the fact that when the last AOL employees turned the office lights off, the assets of AOL went home with them, and Time Warner boasted real assets such as a studio, HBO, a cable company, CNN, and Time, Inc., that made money while sitting in the library. In addition, AOL had annual sales of $4.8 billion in 2000, while Time Warner reached $14.6 billion.
The other funny part is that once Time Warner got in bed with AOL, the latter started to deteriorate with inferior services and lack of innovations.
When Time Warner “acquired” AOL, there were 20 million subscribers. When it spun it off last March, it had fallen to 6.3 million. In 2000, AOL was valued at $166 billion; nowadays it’s $5.66 billion. I guess there is no need to continue. You get the message. What I’d like to reinforce, however, is the same message that I’ve been barking about since the year 2000, when I was in fact smarter than a fifth grader and the corporate people were not, despite their MBA degrees and my incomplete undergraduate studies.
An impressive body of academic studies exist that all predicted the merger was doomed from the start. Stealing Time, a book published in 2003 (by Alec Klein from Simon & Schuster), described the AOL-Time Warner merger as two big businesses gone awry through cockiness, lack of principles and poor judgment. The book points out that in this case, MBAs cannot be faulted, since Steve Case, one of the merger’s architects and AOL CEO, wasn’t accepted by several MBA programs after college while working as a pizza taster for Pizza Hut. Some of the studies centered on the so-called “Q ratio,” which calculates the replacement value of a company’s total assets. In addition, this factor assigns a higher Q ratio to more focused companies than more diversified companies engaged in vertical integration.
In my view, when a television company decides to control the whole supply chain, it incurs more than just a low Q ratio, but also risky undertakings that usually drag down the stock value of the whole group. This is why the sum of all parts is always greater than the group. Years ago, the U.S. TV networks picked the best shows from producers, gave back the ones proven to be duds and risked nothing in the process. That’s why they were called “licenses to print money.” Nowadays, a costly, low-rated show produced by the same network has to be “amortized,” which means that the network is losing twice: It can’t monetize the show and is not getting the ratings.
Not that horizontal integrations are any better. The typical example is when Paramount purchased Spelling Entertainment, which owned Worldvision Distribution, for $8.2 billion in 2000. At that time, the New York-based distribution company was generating close to $100 million a year, spending just 10 percent as cost to do business. The accountants at Paramount decided to save those $10 million a year by incorporating the sales within its own distribution system. The result was that the revenues from the Worldvision library went down to an estimated $60 million. So, in order to save $10 million, Paramount lost $30 million.
This because the studios’ priority is to sell new series, not library material. Besides, international television programmers don’t buy in bulk from the same company, but rather tend to spread their acquisition budgets among the various studios, not knowing where the next hit will be coming from.
In conclusion, if these “My 2¢” failed to make a dent in the corporate chieftains’ business practices, let’s simply indulge in imagining how great it would be if owners such as Sumner Redstone (Viacom, Paramount) and Rupert Murdoch (News Corp) would spin off most of their companies, similar to what Time Warner did with AOL. The difference in these cases is that there would not be any losers, only winners, and finally, the end of this senseless business “philosophy” called vertical integration, a.k.a. selling to oneself.
Vertical Integration Definition The degree to which a firm owns its upstream suppliers and its downstream buyers is referred to as vertical integration. Because it can have a significant impact on a business unit's position in its industry with respect to cost, differentiation, and other strategic issues, the vertical scope of the firm is an important consideration in corporate strategy.
Expansion of activities downstream is referred to as forward integration, and expansion upstream is referred to as backward integration.
The concept of vertical integration can be visualized using the value chain. Consider a firm whose products are made via an assembly process. Such a firm may consider backward integrating into intermediate manufacturing or forward integrating into distribution. Two issues that should be considered when deciding whether to vertically integrate are cost and control. The cost aspect depends on the cost of market transactions between firms versus the cost of administering the same activities internally within a single firm. The second issue is the impact of asset control, which can impact barriers to entry and which can assure cooperation of key value-adding players. Benefits of Vertical Integration:
Reduce transportation costs if common ownership results in closer geographic proximity
Improve supply chain coordination.
Provide more opportunities to differentiate by means of increased control over inputs
Capture upstream or downstream profit margins.
Increase entry barriers to potential competitors, for example, if the firm can gain sole access to a scarce resource.
Gain access to downstream distribution channels that otherwise would be inaccessible.
Facilitate investment in highly specialized assets in which upstream or downstream players may be reluctant to invest.
Lead to expansion of core competencies
Drawbacks of Vertical Integration
Capacity balancing issues. For example, the firm may need to build excess upstream capacity to ensure that its downstream operations have sufficient supply under all demand conditions
Potentially higher costs due to low efficiencies resulting from lack of supplier competition
Decreased flexibility due to previous upstream or downstream investments. (Note however, that flexibility to coordinate vertically-related activities may increase.)
Decreased ability to increase product variety if significant in-house development is required
Developing new core competencies may compromise existing competencies
Increased bureaucratic costs
Week 2:
Economies of Scope The AOL Time Warner merger presented an opportunity for economies of scope by allowing Time Warner to distribute its vast media library (magazines, music, television, movies) via AOL's internet technology. Following the merger, the combined entity was unwieldy in size (90,000 employees) and was slow in reacting to the rapidly changing market.
Although the opportunity for economies of scale existed in theory, the reality was that many of the expected scope economies were misleading. Cross-promotional activities may have boosted demand, but they came at the expense of selling promotional space to outside entities. Consumers preferred the freedom to download whatever content they wished (and the freedom to do so offered by broadband providers) rather than be force-fed whatever their service provider offered. The popularity of music downloads was an especially big blow to AOL Time Warner’s dream of dominating through content.
Economies of scope are conceptually similar to economies of scale. Whereas 'economies of scale' for a firm primarily refers to reductions in average cost (cost per unit) associated with increasing the scale of production for a single product type, 'economies of scope' refers to lowering average cost for a firm in producing two or more products. The term and concept development are due to Panzar and Willig (1977, 1981). Here, economies of scope make product diversification efficient if they are based on the common and recurrent use of proprietary know-how or on an indivisible physical asset. For example as the number of products promoted is increased, more people can be reached per dollar spent. At some point, additional advertising expenditure on new products may start to be less effective (an example of diseconomies of scope).
If a sales force is selling several products they can often do so more efficiently than if they are selling only one product. The cost of their travel time is distributed over a greater revenue base, so cost efficiency improves. There can also be synergies between products such that offering a complete range of products gives the consumer a more desirable product offering than a single product would. Economies of scope can also operate through distribution efficiencies. It can be more efficient to ship a range of products to any given location than to ship a single type of product to that location.
Further economies of scope occur when there are cost-savings arising from by-products in the production process. An example would be the benefits of heating from energy production having a positive effect on agricultural yields.
A company which sells many product lines, sells the same product in many countries, or sells many product lines in many countries will benefit from reduced risk levels as a result of its economies of scope. If one of its product lines falls out of fashion or one country has an economic slowdown, the company will, most likely, be able to continue trading.
Not all economists agree on the importance of economies of scope. Some argue that it only applies to certain industries, and then only rarely.
A decade ago, America Online merged with Time Warner in a deal valued at $350 billion, which is still the largest merger in American business history. But the trail of despair in subsequent years produced a deal now regarded by many as a colossal mistake.
At the time of the merger, AOL had 27 million subscribers, amounting to about 40% of total US online subscribers. AOL grew in just eight years from a small Internet start-up, competing with the likes of Prodigy and the commented CompuServe (which was acquired in 1998), into a media conglomerate. On the way, the drivers of its profitability and growth have shifted from subscriptions and usage time to advertising and e-commerce deals.
Despite the change in its strategy, one of AOL's features has been its pursuit to make ensure that investors understand its business model. Since 1996, when it began its transformation from computer-networking company to media giant, AOL made changes in its strategic direction to the investment community, even when doing so might have seemed perverse or damaging. The market registered with strong approval. AOL's stock price increased 1,468% from October 1996 to January 2001, compared with a 100% increase in the S&P 500, which AOL joined in December 1998.
The reason for the merger was allow each of the companies to get a piece of the Internet future which each of the companies could not provide for individually. For AOL, the merger was about technology: America Online was the dominant leader in what might be termed the sort of first stage of Internet usage, that is, people was going on-line for e-mail and Web surfing. But AOL did not have a strategy for the next generation of internet users who would require broadband access (where access to the Internet would be much faster and would allow users the ability to complete much more complicated tasks like media downloading, telephony, gaming, virtual offices, etc):
On the surface, what happened Monday is simple: AOL, the leading provider of dialup Internet service, needed a strategy for moving its customers forward into the much-ballyhooed world of high-speed "broadband" access, controlled by telephone companies and cable TV operators (such as Time Warner). Time Warner, the ungainly media conglomerate, needed a credible way to salvage its Internet strategy after a decade of failure in the digital realm -- from the colossal flop of its "Full Service Network" interactive television experiment to the spectacular flameout of its misconceived Pathfinder Web portal.
Put the two companies together and you get something like Monday morning's press conference announcing the deal: A torrent of references to "synergy," "one plus one equals three," "the media value chain," "the convergence of media, entertainment and communications," and "new benefits to consumers." You also get an avalanche of hype: One analyst declared, "It is probably the most significant development in the Internet business world to date."1
For AOL’s Board of Directors, the portfolio of brands created with the merger of the two companies would cover the full spectrum of media entertainment and information, and this would led the company increase the revenues at the three major areas that had AOL: subscriptions, advertising and e-commerce and content. They believed that Time Warner’s cable systems would expand the broadband delivery systems for AOL computer service’s technology and, over all, they assured that the new business would be benefited from huge operating synergies (cross-promotion, more efficiency in marketing, cost reductions in launching and operating new technologies) as well as major new business opportunities.
AOL’s subscriber base and advertising revenues were growing exponentially until the crash of 2000 occurred. AOL suffered increasing demand from Wall Street to generate big advertising deals to meet rising expectations. When this failed, AOL resorted to unconventional methods to boost its financial numbers (utilizing legal action for an ad deal, booking E-Bay ad revenues as their own). AOL stock was severely overvalued and this merger was the only way to prevent a collapse in valuation. AOL, as the new corporate giant created by the Internet boom, was using its sky-high value of its stock to acquire an older Fortune 500 company. AOL's high market capitalization relative to that of Time Warner made the acquisition possible.
Viewing back upon the merger several reasons can be found why the merger did not work out as the former managements had hoped it would. One of the main reasons is that AOL basically never was an equal counterpart to Time Warner. At the time of the merger AOL’s stocks were overvalued mainly due to the Internet bubble4. During the 1990 many upcoming Internet start-ups, the so-called dotcoms, were tremendously overvalued and to some extent without ever having made profit worth as much as established blue-chip companies because investors believed in their potential. Indeed only a few companies survived the “new economy”-era and are now established companies (e.g. Amazon or EBay). Since, however, AOL according to its stock price was worth as much as Time Warner at the time of the merger they got the same voting rights and power. There still exists much controversy around Case’s profit taking from the sale of his shares (Exhibit 4):
The fact that Case sold a major part of his AOL stock soon after the merger was announced in January 2000 (when the price of the stock was high) and made an estimated profit of $ 160 million evoked suspicion and anger among shareholders. They thought that Case was aware of the fate of the merger and accused him of making money, when the time was right, at the expense of the shareholders.5
Yet, today AOL is certainly less worth than Time Warner. So, from today’s perspective AOL received a too high price for its share or Time Warner paid too much for what it received in return. The stock price of AOL Time Warner fell from its peak of almost 90 US$ in 2001 down to almost 10 US$ in 2003 and right now is just at 13 US$. Also, since AOL turned out to be an unequal partner AOL Time Warner changed its name back to just Time Warner in the mean time and almost the whole AOL board has been replaced while still many of Time Warner’s directors are in charge6.
Another reason why the merger failed is that in the time after the merger AOL and Time Warner failed to implement their visions and communicate them – e.g. marketing Time Warner content through all channels possible. Additionally, they even lacked the ability to recognize new trends in the digital industry. One trend apart from broadband Internet was Internet telephony or Voice over IP (VoIP). AOL Time Warner as the main player in the digital revolution – as they defined themselves – hardly took notice of this trend and they failed to build a business model for that. Secondly, they were not able to promote their idea of a combined music-platform. Again, it was another company to gain the first mover advantage in this area (Apple with their introduction of the iTunes Music Store). And thirdly, one of the main trends AOL Time Warner missed in the recent years was the importance of highly personalized web services. Examples are MySpace.com, a platform for everyone to express oneself, which was bought by Rupert Murdoch’s News Corp. last year for about $580 million7 or Snapfish, a service that allows everyone to store pictures online and make them publicly available. AOL Time Warner in contrast believed that delivering serious news and facts was more promising than highly personalized content.8
A new thread came up for AOL in the recent years. AOL used to be the most important Internet Service Provider in many countries. However, they failed to offer broadband access as soon as possible. So it was the local phone companies to have the first mover advantage9. As a consequence of this not only lost AOL subscribers to their Internet service but also their portal lost importance leading to a loss in opportunity to promote AOL Time Warner content10. As a further consequence income from advertising is decreasing.11
Furthermore, the CEOs at the time of the merger, Mr. Case and Mr. Levin, still today regard themselves as being the wrong persons for having done the job at that time. In an interview Case states that not only him but also the whole board of directors in each of the companies really believed in the success of his idea; yet he admits that he was the one to blame for the failure since it was his idea. Indeed at that time AOL needed Time Warner’s broadband and cable business as a strong partner for further growth12. In contrast, it is to question whether Time Warner really needed AOL or whether a strategic partnership wouldn’t have been the better choice13. One major mistake seems to have been in the assumptions about the merger itself. Time Warner was thinking it was they to mainly benefit from the merger since they could access AOL’s media channels and promote their content through it. AOL in contrast was the party that gained most through the merger because they were able to use Time Warner’s broadband cable network and extend their broadband business.14
A final reason for the failure is the fact that AOL and Time Warner were not able to encourage a climate within the companies to initiate the synergies that were proposed. As Peter S. Fader, a Wharton marketing professor, says it is impossible to manufacture synergies, oftentimes they are just nothing more than serendipities.15 A clear and concise strategy never emerged from the two companies:
Wharton business and public policy professor Gerald Faulhaber has heard this spiel before. “AOL is an enormous asset, but it has a management problem,” says Faulhaber. “AOL has the audience, but Time Warner has demonstrated that it doesn't know how to take advantage of it.” There are plenty of unanswered questions about AOL, Faulhaber adds. For example, what does AOL have to become in the future? What can AOL create that's unique? How can it garner profits from its instant messaging dominance? How will it convince its customers to stick with AOL as broadband Internet access grows in popularity?16
Even though there was hope for a complete integration of the companies and the ability of both companies to leverage the others strengths, this never materialized. The integration of services which was editorialized by many cartoonists (Exhibit 3) never occurred.
Kwin Raymer
MEMO 8
To: Strategy Group
From: COO
Re: Ramifications of AOL Divesture
I need your immediate input regarding the potential impact on our bottom line of selling our AOL unit. For obvious reasons, it is imperative that you treat this request as confidential.
INTRODUCTION
.
In January 2000, the Internet pioneer, America Online, agreed to buy Time Warner for $165 billion in what would become the biggest merger in history. Time Warner was considered the largest traditional media company, and the merger served as evidence that old and new media were beginning to converge.
“The merger of AOL and Time Warner involved a vertical combination of the largest Internet content provider and aggregator and a large cable system operator which offered a conduit through which broad-band customers could access Internet content at high speeds.” 1
AOL’s nearly 30 million paying customers worldwide were positioned to gain access to Time Warner's entertainment and information empire and were also positioned to potentially switch from using modems and telephone lines to go online to accessing the Internet via Time Warner's cable television systems. Those cable systems, which served 13 million subscribers at the time, would have enabled AOL to start offering much faster Internet and interactive television services. It is worthy of note that until this deal was stuck, no major cable company would carry AOL services.2 At the time of the merger, demand for dial up services was still very strong as broadband services had yet to gain significant market penetration.
.
BACKGROUND
.
Business Perspective
From a business perspective, the merger marked the blending of traditional and new media to exploit the opportunities offered by each entity; seemingly, the union made sense for both AOL and Time Warner. Between the two organizations, all of the integral components were in place to achieve success in the internet business - a strong customer base, appealing content, and proven distribution methods.
AOL was a successful and established gateway to the internet that was somewhat lacking in original content while Time Warner held a wealth of material in the form of news, films and cartoons but lacked the internet presence or know-how to distribute it effectively. AOL was in the position to use its well-established brand on the web as well as its proven strategies of using the internet to provide information and entertainment.” 3
.
Economics Perspective
.
From an economic perspective, the primary advantages that AOL and Time Warner sought to gain from the merger related to complementary services and vertical integration. Michael Baye defines complements as “goods for which an increase (decrease) in the price of one good leads to a decrease in the demand for the other good.” 4 “Economic complementarity occurs when some inputs are used together within consumption/production bundles and some additional utility/output are generated by the bundles, other than the individual inputs.” 5 Opportunities abounded for the bundling of services including having AOL subscribers potentially retain exclusive rights to view the online versions of Time Warner content.
In the case of AOL and Time Warner, complementary products include the internet connectivity of AOL and the content of Time Warner. By merging, complementary firms have the opportunity to reduce their pricing externality and become more aggressive competitors when compared to substitute firms. The post-merger reductions in price should serve to both harm competitors and benefits consumers. However, for insiders, the shape of the demand curve will determine the profitability of the merger. 6
Baye defines vertical integration as “a situation where a firm produces the inputs required to make its final product”. 4 The benefits of vertical integration include improving supply chain coordination, providing more opportunities to differentiate by means of increased control over inputs, capturing upstream or downstream profit margins, increasing entry barriers to potential competitors, gaining access to downstream distribution channels, facilitating investment in highly specialized assets in which upstream or downstream players may be reluctant to invest, and expanding core competencies.7 For this merger, vertical integration was represented by the fact that the combined company could both produce content and deliver it via various channels.
Time Warner also stood to take advantage of the powerful network that AOL had built in terms of subscribers. This powerful network consisting of nearly 30 million worldwide subscribers was a captive market that was well-positioned to receive Time Warner content via the Internet. Though AOL subscribers used the AOL service as a method of accessing the Internet, they also stood to gain additional value from the network complementaries that would arise when Time Warner provided them with new content via the AOL interface.
.
REASONS FOR FAILURE
.
By most accounts, economic factors were not to blame for the failure of the AOL-Time Warner merger; instead, the failure to take advantage of the benefits of complements and vertical integration are largely considered the source of blame. For example, the large combined company never was able to adequately find a way to distribute the Time Warner content via AOL’s interface. While attempting to implement these pre-merger objectives, the company missed out on the changing landscape of the Internet industry. A particularly difficult blow to the company was AOL’s loss of dial-up subscribers who left for broadband options. This massive loss of subscribers diminished one of AOL’s primary assets—subscribers. At the same time, the company was unable to capitalize on other new industry trends such as music downloading and social media. “Even though there was hope for a complete integration of the companies and the ability of both companies to leverage the others’ strengths, this never materialized.”8 Internal clashes of corporate cultures is another oft-mentioned reason that the two entities were not able to take advantage of opportunities.
.
DIVESTING
.
“If firms want their strategic business units to supply or buy from each other, they should frequently reexamine their premises for such arrangements, because the strategic window that favored vertical integration can close.” Furthermore, “firms can act early and purposefully to lower exit barriers by limiting the degree, stages, and percentage of ownership that characterize their vertical relationships. Strategists must scan the effects of vertical integration on strategic flexibility just as they scan other forces that erect exit barriers.” 9
The same lack of integration that caused the merger to fail would also allow for the firms to split with a relatively minimal impact on Time Warner. AOL’s contribution revenues and intersegment revenues were the smallest within Time Warner in 2008. In addition, the contribution of AOL to Time Warner revenues (in both total and as a percent of contribution) was declining for several years. As such, spinning off AOL should limit Time Warner’s losses to the losses of future advertising revenue and to a lesser extent, subscription revenue.
.
THE NUMBERS
.
12
.
POST-MERGER UPDATE:
.
Since splitting from Time Warner, AOL has been struggling to reinvent itself as a modern media company. Nearly ten years have passed since AOL was considered one of the most promising firms in the online realm. Today, its future appears uncertain as the former titan attempts to regain a position as a major Internet presence. In September 2009, J.P. Morgan valued the AOL at approximately $4 billion, a fraction of the $161 billion it was valued at when it acquired Time Warner in 2001. 10
.
LESSONS LEARNED:
.
What lessons can be learned from one of the biggest failed mergers in history? While the merger may make economic sense on paper, it is also important to consider:
- Shareholders from new companies and established companies have very different expectations. Keeping both groups of shareholders happy will be a challenge.
- Similarly, the corporate cultures from a new tech company and an established traditional media company are likely to encounter difficulty. The differences in ages, styles and expectations among the two workforces were difficult to reconcile. 11
.CASE QUESTIONS:
.
1. In economics, a complement refers to:
a. Goods for which an increase (decrease) in the price of one good leads to an increase (decrease) in the demand for the other good.
b. Goods for which an increase (decrease) in the price of one good leads to a decrease (increase) in the demand for the other good.
c. The value of the output produced by the last unit of an input.
d. A situation where a firm produces the inputs required to make its final product.
2. Which of the following was not commonly mentioned as a reason that this merger was not a success?
a. Clashes of corporate cultures
b. Lack of demand for internet services
c. Inability to take advantage of complementary products and services
d. None of the above
3. Declining demand of what AOL product or service lead to a sharp decrease in subscription revenue?
a. Advertising
b. News content
c. Dial-up service
d. Time Warner movies
4. From 2005 to 2008, what was the percentage change in AOL’s subscription revenue?
a. +71.44 %
b. -49.98 %
c. -17.65 %
d. -71.44 %
5. Excluding intersegment revenue, how much revenue (in millions) did AOL contribute to Time Warner in 2008?
a. $8,090
b. $5,098
c. $4,165
d. $1,457
Answer Key:
SOURCES:
SUMMARIES:
Comparative advantage and trade (How do you determine your comparative advantage?)
A comparative advantage in producing or selling a good is possessed by an individual or country if they experience the lowest opportunity cost in producing the good. Examples include Apple Corporation (marketing), Pakastani apparel (low cost), and Columbian illegal goods and services (drugs). There are a variety of reasons why individuals, firms, and countries gain a comparative advantage, and even more so, how it is determined a comparative advantage exists at all.
Concentration Ratios
A concentration ratio is a measure of the total output produced in an industry by a given number of firms in the industry. Examples of concentration measures include Pivotal Supplier Index, Residual Supply Index, Four-Firm Concentration Ratio, Eight-Firm Concentration Ratio, Herfindahl-Hirschman Index, Rothschild Index, and the Lerner Index. As with all statistical data, concentration indexes should always be interpreted with caution as they have several potential limitations.
Economies of scale, diseconomies of scale, constant returns to scale, Efficiency in production
Economies of scale exist when long-run average costs decline as output is increased. For example, larger companies are able to purchase input goods in higher quantity and benefit from discounts on the bulk orders. This results in lower average costs in the long run.
Diseconomies of scale exist when long-run average costs rise as output is increased. For example, smaller companies can suffer from diseconomies of scale due to their lack of capital.
Constant returns to scale exist when long-run average costs remain constant as output is increased. For example, in some industries average costs will scale in proportion with output. This can be achieved with the proper use of technology and software.
Efficiency in production refers to the ability to produce a good using the fewest resources possible. Efficient production is achieved when a product is created at its lowest average costs. In order to gauge production efficiency managers can use three measures of productivity, total product, average product, and marginal product.
Market Failure
When a market fails it is unable to provide the socially efficient quantities of goods. There are many reasons a market can fail including: anti-competitive market power, negative externalities, public goods, and rent seeking.
A firm with market power has the ability to set its price above marginal cost. A monopoly is a good example of a market in which a firm produces less than a socially efficient level of output. The welfare that would have accrued to society if the industry were perfectly competitive but is not realized because of the market power the monopolist enjoys is the deadweight loss.
Negative externalities are costs borne by parties who are not involved in the production or consumption of a good. The most common example of a negative externality is pollution.
A public good is a good that is non-rival and non-exclusionary in consumption and is another way a market can fail.
Rent seeking refers to self-motivated efforts aimed at influencing another party’s decision. Government policies generally benefit some parties at the expense of others.
Property Rights and Incentives
Property rights refer to the ability to use one's properties in any manner that the owner chooses. Along with this utilization, an owner also exercises the ability to incur financial gains (or losses) based upon that usage.
Tragedy of the commons refers to a situation in which a resource will eventually cease to exist or be usable. In the long term, this would be detrimental to the overall economy of the society which has destroyed this resource. When no private property rights exist and a resource is accessible to large groups, tragedy of the commons is likely to occur. Government monitoring, taxes, fees, fines, and implementation and enforcement of regulations are all ways to combat this.
Week 6:
The ABCs of complementary products mergers
The article above discusses issues related to mergers between firms of complementary products. Specifically, the article refers to the oligoply models that we are covering in class.
The article concludes that "By merging, complementary firms reduce their pricing externality and become more aggressive competitors vis-`a-vis substitute firms. This reduces prices and thus harms outsiders and benefits consumers. The shape of the demand curve determines whether a merger is profitable to insiders."
Week 5:
What was the hope of the AOL-Time Warner Merger?
Why do such big players want to merge?
The merger marks the coming together of traditional and new media to exploit the opportunities offered by each. It makes overwhelming sense for both AOL and Time Warner.
Together they have the cocktail of ingredients to succeed in the internet business - a strong customer base, appealing content, and ways to distribute it.
AOL seeks to portray itself as a gateway to the internet, with its homepage as the starting point for exploring the web. But it lacks its own content to attract more users to the service.
As one of the world's leading media companies, Time Warner has a wealth of material, such as news, films and cartoons, that it could offer through the web. But it does not have the internet presence or know-how to do this effectively.
It has pumped millions into internet ventures but has failed so far to make an impact in cyberspace.
What can both companies offer each other?
Time Warner brings to the deal a whole raft of media interests.
It owns several cable television channels such as CNN, TNT, HBO and the Cartoon Network. It also publishes the magazine Time and People. And it has music and film interests, behind blockbusters such Blade, The Cell and The Matrix.
As the world's largest internet service, AOL brings more than 30m subscribers to the deal, as well as a well-established brand on the web. But more importantly, it brings tried and tested strategies of using the internet to provide information and entertainment.
Mergers with Bundling in Complementary Markets
This model suggests that mergers with bundling in systems markets could entail both pro-competitive and anti-competitive effects. In the event of any foreclosure of competitors, however, conglomerate mergers with mixed bundling would be predominantly anti-competitive. Even in the absence of such foreclosure effects, there is no clear-cut answer to how mixed bundling by the merging parties would affect consumer and social welfare. With heterogeneous consumer preferences, some buyers gain and others lose. For instance, those who previously purchased both products from the two merging firms would gain due to the lower bundle price. However, those who continue to purchase a mix-and-match system would suffer due to the increased stand-alone prices charged by the merged firm. As a result, the overall impact on consumer and social welfare is ambiguous.
In general, conglomerate mergers would have different implications for competition depending on specific market conditions such as market shares of the merging parties in their individual markets, economies of scale due to avoidable fixed costs, ease of entry, etc. To sort out pro-competitive effects and anti-competitive effects of each conglomerate merger case, the relative magnitudes of these countervailing effects and the likelihood of the foreclosure of one or more competitors need to be assessed. Blanket approvals of conglomerate mergers with the presumption that bundling is either pro-competitive or competitively neutral are certainly not warranted.
Week 4:
AOL finally regains independence from Time Warner (USA Today, 12/10/2009)
NEW YORK — AOL resumed life as an independent Internet company Thursday as it completed its spinoff from Time Warner Inc. and closed the book on one of the most disastrous business combinations in history.
AOL shares fell 59 cents, or 2.5%, to $23.08 in midday trading.
Today's AOL is much different from the company once known as America Online, which got big in the 1990s by selling dial-up Internet access and then used $147 billion of its inflated stock to buy Time Warner. AOL, which is now worth about $2 billion, is trying to get most of its money from running advertisements on its portfolio of websites.
Those sites include the AOL.com home pages, Mapquest and tech blog Engadget. AOL isn't keeping the entertainment site TMZ, which is staying in Time Warner.
When AOL bought Time Warner in 2001, the companies bet that Time Warner's TV and magazine content would complement AOL's Internet business. Instead, broadband Internet connections began to kill off AOL's main source of revenue and drag down the whole company.
The company was once known as AOL Time Warner but dropped AOL from the name in 2003. That was a sign of what was to come: Time Warner announced AOL's spinoff last May after years of trying to integrate the two companies.
In a note to clients, BMO Capital Markets analyst Jeffrey Logsdon called the failed deal "a nine-year adventure akin to a marathon through the mud."
The new AOL has no debt. The company is profitable, though its operating income dropped 50% to $134 million in the third quarter from the same period a year earlier. Third-quarter revenue dropped 23% from last year to $777 million.
In the past year, AOL hired Tim Armstrong, 38, a former Google advertising executive, as CEO. Armstrong plans to cut up to 2,500 jobs, or more than a third of AOL's employees, on top of thousands of other cuts in recent years.
That will leave the company at less than a quarter the size it was at its peak in 2004.
The company plans to fill many of its websites with inexpensive material produced by freelancers paid by the post. This week it said it had hired New York Times reporter Saul Hansell to oversee part of that content-generation effort.
Complement Definition
A complement refers to a good or service that is used in conjunction with another good or service. Usually, the complementary good has little to no value when consumed alone but, when combined with another good or service, it adds to the overall value of the offering. Also, good tends to have more value when paired with a complement than it does by itself.
A product can be considered a complement when it shares a beneficial relationship with another product offering. In an economic sense, when the price of a good rises, the demand for its complement will fall because consumers don't want to use the complement alone.
For example, if the price of hot dogs rises so much that people stop consuming them, this will also cause a decrease in demand for hot dog buns. Because the price of hot dogs has an inverse relationship to the demand for hot dog buns, we call them complementary products.
Week 3:
Vertical Integration:
AOL Marks The End of Vertical Integration
By Dom Serafini
I guess that in the corporate world, there’s no easy way to do things. That it was a bad idea for Time Warner to buy AOL in 2000 was well known by most people, apart from Time Warner’s executives. They may have thought they were smarter than a fifth grader but instead got awful marks for their actions.
The funny part was that it was actually AOL that bought Time Warner, because the market value of the tech company was much higher than that of the venerable studio and publishing group. Time Warner was acquired by AOL for $182 billion, by putting up $166 billion of its overpriced stock for 55 percent of the combined company, (and not a single cent of “real” money). This despite the fact that when the last AOL employees turned the office lights off, the assets of AOL went home with them, and Time Warner boasted real assets such as a studio, HBO, a cable company, CNN, and Time, Inc., that made money while sitting in the library. In addition, AOL had annual sales of $4.8 billion in 2000, while Time Warner reached $14.6 billion.
The other funny part is that once Time Warner got in bed with AOL, the latter started to deteriorate with inferior services and lack of innovations.
When Time Warner “acquired” AOL, there were 20 million subscribers. When it spun it off last March, it had fallen to 6.3 million. In 2000, AOL was valued at $166 billion; nowadays it’s $5.66 billion. I guess there is no need to continue. You get the message.
What I’d like to reinforce, however, is the same message that I’ve been barking about since the year 2000, when I was in fact smarter than a fifth grader and the corporate people were not, despite their MBA degrees and my incomplete undergraduate studies.
An impressive body of academic studies exist that all predicted the merger was doomed from the start. Stealing Time, a book published in 2003 (by Alec Klein from Simon & Schuster), described the AOL-Time Warner merger as two big businesses gone awry through cockiness, lack of principles and poor judgment. The book points out that in this case, MBAs cannot be faulted, since Steve Case, one of the merger’s architects and AOL CEO, wasn’t accepted by several MBA programs after college while working as a pizza taster for Pizza Hut. Some of the studies centered on the so-called “Q ratio,” which calculates the replacement value of a company’s total assets. In addition, this factor assigns a higher Q ratio to more focused companies than more diversified companies engaged in vertical integration.
In my view, when a television company decides to control the whole supply chain, it incurs more than just a low Q ratio, but also risky undertakings that usually drag down the stock value of the whole group. This is why the sum of all parts is always greater than the group. Years ago, the U.S. TV networks picked the best shows from producers, gave back the ones proven to be duds and risked nothing in the process. That’s why they were called “licenses to print money.” Nowadays, a costly, low-rated show produced by the same network has to be “amortized,” which means that the network is losing twice: It can’t monetize the show and is not getting the ratings.
Not that horizontal integrations are any better. The typical example is when Paramount purchased Spelling Entertainment, which owned Worldvision Distribution, for $8.2 billion in 2000. At that time, the New York-based distribution company was generating close to $100 million a year, spending just 10 percent as cost to do business. The accountants at Paramount decided to save those $10 million a year by incorporating the sales within its own distribution system. The result was that the revenues from the Worldvision library went down to an estimated $60 million. So, in order to save $10 million, Paramount lost $30 million.
This because the studios’ priority is to sell new series, not library material. Besides, international television programmers don’t buy in bulk from the same company, but rather tend to spread their acquisition budgets among the various studios, not knowing where the next hit will be coming from.
In conclusion, if these “My 2¢” failed to make a dent in the corporate chieftains’ business practices, let’s simply indulge in imagining how great it would be if owners such as Sumner Redstone (Viacom, Paramount) and Rupert Murdoch (News Corp) would spin off most of their companies, similar to what Time Warner did with AOL. The difference in these cases is that there would not be any losers, only winners, and finally, the end of this senseless business “philosophy” called vertical integration, a.k.a. selling to oneself.
Why Vertical Integration is Making a Comeback (HBR)
Vertical Integration Definition
The degree to which a firm owns its upstream suppliers and its downstream buyers is referred to as vertical integration. Because it can have a significant impact on a business unit's position in its industry with respect to cost, differentiation, and other strategic issues, the vertical scope of the firm is an important consideration in corporate strategy.
Expansion of activities downstream is referred to as forward integration, and expansion upstream is referred to as backward integration.
The concept of vertical integration can be visualized using the value chain. Consider a firm whose products are made via an assembly process. Such a firm may consider backward integrating into intermediate manufacturing or forward integrating into distribution.
Two issues that should be considered when deciding whether to vertically integrate are cost and control. The cost aspect depends on the cost of market transactions between firms versus the cost of administering the same activities internally within a single firm. The second issue is the impact of asset control, which can impact barriers to entry and which can assure cooperation of key value-adding players.
Benefits of Vertical Integration:
Drawbacks of Vertical Integration
Week 2:
Economies of Scope
The AOL Time Warner merger presented an opportunity for economies of scope by allowing Time Warner to distribute its vast media library (magazines, music, television, movies) via AOL's internet technology. Following the merger, the combined entity was unwieldy in size (90,000 employees) and was slow in reacting to the rapidly changing market.
Although the opportunity for economies of scale existed in theory, the reality was that many of the expected scope economies were misleading. Cross-promotional activities may have boosted demand, but they came at the expense of selling promotional space to outside entities. Consumers preferred the freedom to download whatever content they wished (and the freedom to do so offered by broadband providers) rather than be force-fed whatever their service provider offered. The popularity of music downloads was an especially big blow to AOL Time Warner’s dream of dominating through content.
Definition:
Economies of scope are conceptually similar to economies of scale. Whereas 'economies of scale' for a firm primarily refers to reductions in average cost (cost per unit) associated with increasing the scale of production for a single product type, 'economies of scope' refers to lowering average cost for a firm in producing two or more products. The term and concept development are due to Panzar and Willig (1977, 1981). Here, economies of scope make product diversification efficient if they are based on the common and recurrent use of proprietary know-how or on an indivisible physical asset. For example as the number of products promoted is increased, more people can be reached per dollar spent. At some point, additional advertising expenditure on new products may start to be less effective (an example of diseconomies of scope).
If a sales force is selling several products they can often do so more efficiently than if they are selling only one product. The cost of their travel time is distributed over a greater revenue base, so cost efficiency improves. There can also be synergies between products such that offering a complete range of products gives the consumer a more desirable product offering than a single product would. Economies of scope can also operate through distribution efficiencies. It can be more efficient to ship a range of products to any given location than to ship a single type of product to that location.
Further economies of scope occur when there are cost-savings arising from by-products in the production process. An example would be the benefits of heating from energy production having a positive effect on agricultural yields.
A company which sells many product lines, sells the same product in many countries, or sells many product lines in many countries will benefit from reduced risk levels as a result of its economies of scope. If one of its product lines falls out of fashion or one country has an economic slowdown, the company will, most likely, be able to continue trading.
Not all economists agree on the importance of economies of scope. Some argue that it only applies to certain industries, and then only rarely.
Week 1:
BACKGROUND INFO:
10th Anniversary of the AOL-Time Warner Merger
A decade ago, America Online merged with Time Warner in a deal valued at $350 billion, which is still the largest merger in American business history. But the trail of despair in subsequent years produced a deal now regarded by many as a colossal mistake.
AOL Quietly Returns to Life on Its Own
AOL began trading as its own public company again after its long-planned spin-off from Time Warner was finally made official.
**Market Situation Prior Merger**
At the time of the merger, AOL had 27 million subscribers, amounting to about 40% of total US online subscribers. AOL grew in just eight years from a small Internet start-up, competing with the likes of Prodigy and the commented CompuServe (which was acquired in 1998), into a media conglomerate. On the way, the drivers of its profitability and growth have shifted from subscriptions and usage time to advertising and e-commerce deals.
Despite the change in its strategy, one of AOL's features has been its pursuit to make ensure that investors understand its business model. Since 1996, when it began its transformation from computer-networking company to media giant, AOL made changes in its strategic direction to the investment community, even when doing so might have seemed perverse or damaging. The market registered with strong approval. AOL's stock price increased 1,468% from October 1996 to January 2001, compared with a 100% increase in the S&P 500, which AOL joined in December 1998.
**Reasons for Merger**
The reason for the merger was allow each of the companies to get a piece of the Internet future which each of the companies could not provide for individually. For AOL, the merger was about technology: America Online was the dominant leader in what might be termed the sort of first stage of Internet usage, that is, people was going on-line for e-mail and Web surfing. But AOL did not have a strategy for the next generation of internet users who would require broadband access (where access to the Internet would be much faster and would allow users the ability to complete much more complicated tasks like media downloading, telephony, gaming, virtual offices, etc):
On the surface, what happened Monday is simple: AOL, the leading provider of dialup Internet service, needed a strategy for moving its customers forward into the much-ballyhooed world of high-speed "broadband" access, controlled by telephone companies and cable TV operators (such as Time Warner). Time Warner, the ungainly media conglomerate, needed a credible way to salvage its Internet strategy after a decade of failure in the digital realm -- from the colossal flop of its "Full Service Network" interactive television experiment to the spectacular flameout of its misconceived Pathfinder Web portal.
Put the two companies together and you get something like Monday morning's press conference announcing the deal: A torrent of references to "synergy," "one plus one equals three," "the media value chain," "the convergence of media, entertainment and communications," and "new benefits to consumers." You also get an avalanche of hype: One analyst declared, "It is probably the most significant development in the Internet business world to date."1
For AOL’s Board of Directors, the portfolio of brands created with the merger of the two companies would cover the full spectrum of media entertainment and information, and this would led the company increase the revenues at the three major areas that had AOL: subscriptions, advertising and e-commerce and content. They believed that Time Warner’s cable systems would expand the broadband delivery systems for AOL computer service’s technology and, over all, they assured that the new business would be benefited from huge operating synergies (cross-promotion, more efficiency in marketing, cost reductions in launching and operating new technologies) as well as major new business opportunities.
AOL’s subscriber base and advertising revenues were growing exponentially until the crash of 2000 occurred. AOL suffered increasing demand from Wall Street to generate big advertising deals to meet rising expectations. When this failed, AOL resorted to unconventional methods to boost its financial numbers (utilizing legal action for an ad deal, booking E-Bay ad revenues as their own). AOL stock was severely overvalued and this merger was the only way to prevent a collapse in valuation. AOL, as the new corporate giant created by the Internet boom, was using its sky-high value of its stock to acquire an older Fortune 500 company. AOL's high market capitalization relative to that of Time Warner made the acquisition possible.
**Reasons for Failure**
Viewing back upon the merger several reasons can be found why the merger did not work out as the former managements had hoped it would. One of the main reasons is that AOL basically never was an equal counterpart to Time Warner. At the time of the merger AOL’s stocks were overvalued mainly due to the Internet bubble4. During the 1990 many upcoming Internet start-ups, the so-called dotcoms, were tremendously overvalued and to some extent without ever having made profit worth as much as established blue-chip companies because investors believed in their potential. Indeed only a few companies survived the “new economy”-era and are now established companies (e.g. Amazon or EBay). Since, however, AOL according to its stock price was worth as much as Time Warner at the time of the merger they got the same voting rights and power. There still exists much controversy around Case’s profit taking from the sale of his shares (Exhibit 4):
The fact that Case sold a major part of his AOL stock soon after the merger was announced in January 2000 (when the price of the stock was high) and made an estimated profit of $ 160 million evoked suspicion and anger among shareholders. They thought that Case was aware of the fate of the merger and accused him of making money, when the time was right, at the expense of the shareholders.5
Yet, today AOL is certainly less worth than Time Warner. So, from today’s perspective AOL received a too high price for its share or Time Warner paid too much for what it received in return. The stock price of AOL Time Warner fell from its peak of almost 90 US$ in 2001 down to almost 10 US$ in 2003 and right now is just at 13 US$. Also, since AOL turned out to be an unequal partner AOL Time Warner changed its name back to just Time Warner in the mean time and almost the whole AOL board has been replaced while still many of Time Warner’s directors are in charge6.
Another reason why the merger failed is that in the time after the merger AOL and Time Warner failed to implement their visions and communicate them – e.g. marketing Time Warner content through all channels possible. Additionally, they even lacked the ability to recognize new trends in the digital industry. One trend apart from broadband Internet was Internet telephony or Voice over IP (VoIP). AOL Time Warner as the main player in the digital revolution – as they defined themselves – hardly took notice of this trend and they failed to build a business model for that. Secondly, they were not able to promote their idea of a combined music-platform. Again, it was another company to gain the first mover advantage in this area (Apple with their introduction of the iTunes Music Store). And thirdly, one of the main trends AOL Time Warner missed in the recent years was the importance of highly personalized web services. Examples are MySpace.com, a platform for everyone to express oneself, which was bought by Rupert Murdoch’s News Corp. last year for about $580 million7 or Snapfish, a service that allows everyone to store pictures online and make them publicly available. AOL Time Warner in contrast believed that delivering serious news and facts was more promising than highly personalized content.8
A new thread came up for AOL in the recent years. AOL used to be the most important Internet Service Provider in many countries. However, they failed to offer broadband access as soon as possible. So it was the local phone companies to have the first mover advantage9. As a consequence of this not only lost AOL subscribers to their Internet service but also their portal lost importance leading to a loss in opportunity to promote AOL Time Warner content10. As a further consequence income from advertising is decreasing.11
Furthermore, the CEOs at the time of the merger, Mr. Case and Mr. Levin, still today regard themselves as being the wrong persons for having done the job at that time. In an interview Case states that not only him but also the whole board of directors in each of the companies really believed in the success of his idea; yet he admits that he was the one to blame for the failure since it was his idea. Indeed at that time AOL needed Time Warner’s broadband and cable business as a strong partner for further growth12. In contrast, it is to question whether Time Warner really needed AOL or whether a strategic partnership wouldn’t have been the better choice13. One major mistake seems to have been in the assumptions about the merger itself. Time Warner was thinking it was they to mainly benefit from the merger since they could access AOL’s media channels and promote their content through it. AOL in contrast was the party that gained most through the merger because they were able to use Time Warner’s broadband cable network and extend their broadband business.14
A final reason for the failure is the fact that AOL and Time Warner were not able to encourage a climate within the companies to initiate the synergies that were proposed. As Peter S. Fader, a Wharton marketing professor, says it is impossible to manufacture synergies, oftentimes they are just nothing more than serendipities.15 A clear and concise strategy never emerged from the two companies:
Wharton business and public policy professor Gerald Faulhaber has heard this spiel before. “AOL is an enormous asset, but it has a management problem,” says Faulhaber. “AOL has the audience, but Time Warner has demonstrated that it doesn't know how to take advantage of it.” There are plenty of unanswered questions about AOL, Faulhaber adds. For example, what does AOL have to become in the future? What can AOL create that's unique? How can it garner profits from its instant messaging dominance? How will it convince its customers to stick with AOL as broadband Internet access grows in popularity?16
Even though there was hope for a complete integration of the companies and the ability of both companies to leverage the others strengths, this never materialized. The integration of services which was editorialized by many cartoonists (Exhibit 3) never occurred.