Playing To Win
Owner Economics & Strategy
Don’t Fall Prey to this Seductive Fallacy
This week I was on the receiving end of an argument that had the same effect on me as waving a red cape in front of a bull. It was the ‘owner economics’ argument, in this case made to justify an acquisition that forward integrated the company (I would have had the same reaction if it had been backward integration). It motivated me to write my 49th Year II Playing to Win/Practitioner Insights piece on Owner Economics & Strategy: Don’t Fall Prey to this Seductive Fallacy. You can find the previous 101 PTW/PI here.
The Owner Economics Argument
I hear this argument over and over from small businesses all the way to giant ones. When a smaller business makes the argument, it typically looks at its biggest purchased input and questions why it pays the supplier’s cost plus a profit margin. Instead, it could produce the input itself and ‘capture the profit margin,’ reaping the benefit of ‘owner economics.’
I see it equally as often in giant companies like Verizon and AT&T. For example, AT&T saw the opportunity to own the content required for current and future service offerings and in October 2016 it reached a deal to acquire Time Warner for $85B. When the acquisition was announced, my friend Geoff Colvin, a senior business reporter at Fortune, called to get my opinion on the strategic logic of the merger. Everyone who had worked on the deal, whether AT&T executive, investment banker, or consultant, waxed eloquent about the strategic logic of the deal, by which AT&T would no longer have to pay a profit markup on its media content, creating an advantage over competitors Verizon and T-Mobile thanks to owner economics.
I was the singular outlier among his many interviews and made three predictions: 1) the acquisition would be disastrous and be unwound within five years; 2) when it was unwound, AT&T would be forced to write off half of the price it paid for Time Warner; and 3) the debacle would end the CEO tenure of Randall Stephenson.
Four and a half years later, AT&T spun off the disastrous Time Warner acquisition, for $43B or 50.6% of purchase price (darn, was off by $500M) and Stephenson ‘retired’ as CEO before the spin off. Thankfully Geoff confirmed my predictions in an article at the time of the spin off. He had called me to ask how on earth I could have predicted these outcomes with so much confidence at the time and with what turned out to be unerring accuracy.
I was highly prepared for his initial call because for during the time of the acquisition, I was serving as the strategy advisor to Lowell McAdam, then the CEO of AT&T’s biggest rival, Verizon. For over a year, I had been fighting a seemingly endless battle to help Lowell resist the siren call of owner economics and the need to acquire one of Time Warner, 20th Century Fox, or CBS/Viacom — all assets valued at over $50B. Lowell, a very savvy CEO, had the conviction that it was a bad idea. But his people and every single outside strategy consulting and investment banking advisor desperately wanted him to make a ‘transformational media content acquisition’ to seize this ‘historic opportunity.’
At the heart of all their pitches was the owner economics theory. In fact, during one meeting, a proponent incredulously asked me: “What kind of a clueless strategist would be willing to forego owner economics?” It was at the heart of AT&T’s argument too. AT&T had to be publicly coy about it because the federal government challenged the deal, and it took until February 2019 to get regulatory approval. Essentially, during the whole time up to approval, AT&T had to argue to the regulators that owner economics didn’t exist — which it argued persuasively enough to persuade the government, sadly for the AT&T shareholders. But when the regulatory permission was attained, AT&T just couldn’t resist bragging about the awesome power of its newly secured owner economics advantage.
The Economics of Vertical Integration
Why was I so confident? The AT&T/TW deal violated the fundamental economics of vertical integration, in this case partial backward integration into an industry that produced what AT&T bundled with other products and sold. (The same economics hold for forward integration, by the way.)
Every business incurs the variable costs of producing its offering (whether product or service). The difference between those variable costs and the price it charges — its variable profit margin — contributes to covering two other costs: fixed costs, and the cost of the capital necessary to operate the business. A sustainably successful business earns a large enough variable profit margin to pay its fixed costs plus earn a profit sufficient to generate the required rate of return on capital.
If a company vertically integrates into an industry of average structural attractiveness and achieves an average competitive position in it, it will earn a return that just meets the required rate with nothing left over for ‘owner economics.’
But of course, vertically integrating companies always want to enter a structurally attractive industry and achieve competitive advantage in it, typically by acquiring an advantaged company. The tricky thing about entering a structurally attractive industry is that it enjoys that attractiveness because there are barriers-to-entry to it. That means that to vertically integrate into it, the entering company has to be able to surmount the barriers to entry. To earn favorable owner economics, the vertically integrating company has to possess a low-cost way of scaling the barriers to entry, which requires that company to have capabilities that others do not, otherwise entry would have already taken place and the structural attractiveness would have already fallen. Thus, the conditions for favorable owner economics by way of forward or backward integration are rarely in place.
AT&T/Time Warner is a classic case of a company (AT&T in this case) entering what it believed to be a structurally attractive industry — media content creation — by way of acquiring a competitively advantaged participant in it — Time Warner. It is arguable that Time Warner was an advantaged company in its industry at the time — it regularly earned a return in excess of its cost of capital. And in 2016, media content creation was considered a wonderfully attractive industry — content was king.
The challenge to the potential for owner economics is the price that the vertically integrating acquiror must pay in cases such as this. The price of Time Warner was steep indeed. It was trading at a market value/book value ratio of 2.8 times in the month before acquisition rumors started to circulate, and on top of that lofty value, AT&T had to pay a control premium of 35% to win Time Warner’s hand.
At this point, the acquiring company, in this case AT&T, has two choices.
On one hand, it can attempt to reap the owner economics by mandating that the Time Warner business provide content to the relevant AT&T businesses at a subsidized rate to help AT&T compete with Verizon and T-Mobile. However, that would reduce Time Warner profitability causing its value to fall from $85B to, well, $43B.
Alternatively, it could avoid that dreadful fate by running the Time Warner business as if it was an independent company and try as best as possible to earn a return enough to justify the control premium on top of the lofty valuation based on structural attractiveness and competitive advantage. That is very difficult, and on top of that, it foregoes all the owner economics that motivated the deal in the first place.
The choice is for the acquired company either to fall greatly in value or be competitively useless to the acquiring company. AT&T blew off $42B of shareholder capital on the horns of that dilemma. [Plus it assumed that structural attractiveness of media content creation would stay high, which it has not due to the massive incoming investments by the tech giants, which also diminished Time Warner’s advantage that it had in a world dominated by linear programming rather than streaming. So, the strategy was dumb even without the fallacious owner economics argument.]
To give credit where credit is due, I learned this principle from the late University of Chicago economist George Stigler who I met shortly after he won the Nobel in Economics in 1982. The nifty concept that he used to explain it to me is that a company can’t use its competitive advantage twice. If you use the competitive advantage of Time Warner to attempt to give AT&T a competitive advantage, you will destroy the value of Time Warner. If you use the competitive advantage of Time Warner for Time Warner, you have nothing to pay for the control premium. You can’t use the competitive advantage of Time Warner to increase the competitive advantage of AT&T.
The Synergy Argument
Whenever I expose the fallacy of owner economics in this way, its proponent tries to wriggle off the hook by making the synergy argument — ah, but there are beneficial synergies between the two vertical levels. Note that this is a completely different claim than the indefensible owner economics argument. Plus, this alternative argument is also almost always fallacious, as was the case with the Time Warner acquisition where AT&T made this argument as well. That is, customers will be wild with enthusiasm when AT&T can bundle together its connectivity service with the content it happens to own thanks to Time Warner. Unfortunately for AT&T, that is not how customers operate. They want to buy exactly the media content they want, from the provider they want, how they want it. If anything, there is a negative impact when you try to force synergy down the customer’s throat (à la Microsoft).
To be of positive value, the act of combining the levels must provide either real benefit to the customer or real improvement the cost structure of the integrated provider. Combining the Windows operating system with Office applications doesn’t create customer value. Mac users run Office on MacOS with equal effect.
Netflix may have had the world believing that it was benefiting from positive synergy between content creation and streaming service — until massive industry-wide investments in content creation have turned that vertical stage from structurally attractive to a bloodbath, plus created a streaming world in which every streamer has plenty of proprietary content.
There are successful cases, such as Apple’s forward integration into retail stores. The upstream business benefited from having a superior retail environment for selling its products. The retail stores benefited from being able to sell an incredibly high value-added product producing off-the-charts sales per sq-ft results. And both the upstream business and customers benefited from the co-location of the Genius Bars — which is in fact a vast network (272 in the US alone) of service/repair nodes.
But this an exception to the rule. It is highly customized and designed to perfectly generate the value from combining. The need for perfect customization is why I can’t think of a single successful vertical case by way of acquisition. The hurdle of finding a perfectly-fitting vertical acquisition is just too high.
My new book, A New Way to Think, addresses 14 flawed models that business people should stop using because they produce damaging rather than beneficial results. The owner economics model could have been the 15th chapter. Like the other 14 models, it sounds good at first blush. Why don’t we capture the profit margin and become more competitive?
But as I have shown, there is no such thing as beneficial owner economics. But that doesn’t stop the model from producing costly errors small and big. For AT&T shareholders, delusional belief in a single flawed model cost them $42B plus five years of focusing on something of zero long term competitive value while its competitors focused on leaping ahead of their distracted competitor.
Don’t buy the fallacy even if literally everyone around you is seduced by it.