November 13, 2017 11:22 AM

The Strange Case of the Inverted Vertical Merger

After a year of not really hearing anything about AT&T's proposed acquisition of Time Warner Entertainment ("TWX"), we learned last week that the deal could be in serious jeopardy from the Antitrust Division of the U.S. Department of Justice ("DoJ" or "Department").  Many of the stories earlier in the week, citing "DoJ sources," suggested that the Department wanted AT&T to sell CNN, in order to gain approval.  In an extensive interview at the New York Times DealBook Conference, AT&T's Chairman, Randall Stephenson put the rumor to rest that CNN was a divestiture the DoJ was seeking, or that AT&T had offered. (See video of the full interview).  
 
Stephenson also noted his "surprise" that the Department would have concerns serious enough to litigate; noting that a vertical merger had not been successfully challenged in court in over 40 years, and that Comcast's acquisition of NBCU had presented much more difficult content problems than AT&T's proposed TWX acquisition.  Stephenson is understandably surprised, because he's absolutely correct on the law.  Nonetheless, the DoJ must have some concern about the deal, so what's going on here?
 
What an Anticompetitive Vertical Merger Looks Like
 
The words "vertical" and "horizontal" are used in antitrust to refer to firms' positions in the supply chain, from creating a product through to its delivery to consumers.  Firms at the same position in the supply chain are, of course, direct competitors, and a merger between them would be called a "horizontal" merger. On the other hand, the merger of a bakery with a grocery store would be an example of a vertical merger--the bakery produces products that are distributed to the public through grocery stores.
 
A vertical merger will rarely present an antitrust problem, unless one or both of the two merging partners has "market power." For example, if the distribution of a service is a monopoly (think local telecommunications services prior to the late 1990's) and a provider of a "competitive" service using this distribution network (like a long distance voice company) wanted to acquire the local telephone exchange, the antitrust agencies would likely be concerned that the acquiring firm may be able to foreclose other long distance companies from being able to continue to access the local distribution network to sell their services to end users, resulting in higher prices to consumers of long distance service.
 
AT&T and TWX

AT&T provides consumer fixed line voice, internet, and multi-channel television service throughout the service territories of its former incumbent local exchange providers. AT&T also provides nationwide mobile voice and internet service through AT&T Wireless, and nationwide multi-channel television service through its satellite (DirecTV) and streaming (DirecTV Now) services. All of the consumer services provided by AT&T are "competitive" services, available from multiple providers.
 
TWX is a worldwide entertainment conglomerate.  Its 3 major divisions are HBO (premium television/streaming entertainment), Turner Broadcasting (includes a number of popular cable channels, including CNN, TBS, and TNT), and Warner Bros. (primarily film and television production/distribution).  The Turner Broadcasting division, it should be noted, owns the rights to broadcast a number of basketball (NBA and NCAA Tournament) and MLB games, as well as assorted sports that no one watches, like golf and women's Irish curling [probably].
 
Nominal Overlap: While generally AT&T distributes the programming of others, it does own some regional sports networks under the "AT&T SportsNet" name. Although AT&T owns the exclusive rights to distribute the games of certain local teams (NBA/NHL/MLB/some NCAA) in Houston, Pittsburgh, Portland, OR, Seattle, and Utah, these regional sports properties do not "compete" with the games that Turner Broadcasting distributes nationally.
 
What Is Going On?
 
Adding to the confusion surrounding the Department's concerns, the reactions from even well-informed commenters have diverged greatly. Because this merger presents nothing exceptional from an antitrust perspective, some, like economist Hal Singer, have concluded that the only reason the DoJ is holding up the deal is to further prosecute President Trump's ongoing personal feud with CNN (owned by TWX).  However, others, like Harold Feld, argue that the DoJ is on the right track and that only large scale divestitures (like all of Turner Broadcasting, or DirecTV) could remedy the competitive problems with this merger.  
 
While Feld makes a compelling case to question the "spite" theory, and he offers the DoJ an ostensible case theory, it's not a convincing argument; as it ignores current market conditions, and relies on a lot of the same, now obsolete, market "assumptions" that the 1992 Cable Act is based on. Of course, this should come as no surprise, since Public Knowledge's current president--Gene Kimmelman--was one of the principle forces behind the Cable Act (on the side of broadcasters).  See, e.g., this NY Times article from 1992.  Note that the 1992 Cable Act continues to richly reward the broadcasters that these ("natural monopoly") arguments favored.  Consumer Reports notes that cable company "price hikes are mainly driven by the rising costs they face for carrying both traditional broadcast networks, such as CBS and Fox, and regional sports channels."
 
The Blind Men and the Elephant
 
Sometimes, as the old fable illustrates, you can't get an accurate picture by focusing on the smallest possible market that could (conceivably) be defined; and this is what I think is going on here.  In Feld's analysis, the post-merger firm is either a distribution colossus (why else would it need to divest DirecTV?), or a "must have" programming hoarder who may well put competitive video distributors (like Comcast?) out of business.  However, to have this opinion one has to explicitly disregard AT&T's stated reason for the deal--to build an advertising platform of the scale to offer competition to the Google/Facebook duopoly on mobile and desktop screens.
 
Public Knowledge, and the other opponents of AT&T's acquisition of DirecTV, ignored the company's stated purpose for that deal--that AT&T needed scale to be a more effective video distribution competitor. Instead, opponents preferred to focus only on the limited number of TV markets that would "lose" a multichannel competitor (those in which AT&T already provided U-verse TV).
 
Three years later, where are we?  Well, customers are continuing to "cut the cord" of traditional pay TV services, like the service offered over AT&T's U-verse.  However, by creating an entirely new video product--DirecTV Now--AT&T has, in less than a year, obtained 800,000 additional customers (a number that represents about 15% of AT&T's entire base of U-Verse TV customers at the time of its DirecTV merger announcement) and 60% of these customers are entirely new customers to AT&T

Said differently, in less than a year of marketing DirecTV Now, AT&T acquired 15% of the customers that took U-Verse TV 10 years to acquire. Rather than losing a choice in a few markets, consumers nationwide gained a choice and acted on it. Thus, consistent with its stated reasoning for acquiring DirecTV, the acquisition allowed it to stimulate output of multichannel video services. Opponents failed to realize the implications of AT&T's DirecTV purchase, in which a new nationwide competitor was created to challenge not only the traditional DirecTV satellite & U-Verse TV services, but also cable companies, other OTT providers, and may have even spurred the entry into the market of newer "large screen" players like Google, Hulu, others.
 
The Opportunity and the Danger
 
The AT&T/TWX merger, as noted by Mark Cuban at a Senate Judiciary Committee Hearing almost a year ago, gives AT&T a chance--and not a very good one, at that (according to Cuban)--to compete against the dominant new media ad giants.  To do this successfully, AT&T will have to, again, expand output of the firm it is acquiring; there simply are not any credible hypotheticals where AT&T "wins" anything by restricting TWX output. 
 
But, if the Department insists on defining the elephant as a snake, based on the shape of its trunk, there is a danger that it leaves existing markets worse off than when it found them.  If, for some crazy reason, AT&T actually agreed to sell off Turner Broadcasting, the only buyer would be another media conglomerate--further concentrating an already highly concentrated market (which is trending toward even greater concentration with Fox-Disney merger rumors) .  Similarly, if AT&T were required to sell off DirecTV, its entire ability to market to a nationwide base of potential video customers would be eliminated--practically guaranteeing that its only profitable strategy would be to restrict output to local market multichannel competitors!
 

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