AT&T — Time Warner Deal Confirms Walled Gardens Future of Entertainment

As Yogi Berra famously said (or not), “It’s like déjà vu all over again.”

The ink has not quite dried on Verizon’s takeover of AOL, let alone its proposed takeover of Yahoo!, and Comcast’s previous acquisition of NBC Universal. Now, AT&T, a telecommunications provider and content distributor, aims to acquire Time Warner, a global content behemoth which owns Warner Bros. film and TV studio, and programming networks such as HBO, CNN and TNT. This is vertical integration, a merger of bandwidth and content.

I’ve written about and discussed this vertical integration and consolidation in media and entertainment in my “Technology Competition & Strategy” MBA course at UC Davis. This course features “platforms” and how they are disrupting business. The media and entertainment industry is deep in the throes of disruption, and vertical integration is motivated by technological changes, including the emergence of over-the-top content distribution, and the economics of bundling.

Proliferation of Digital Distributors and Bundlers

Twenty years ago, Internet service and cable TV were separate businesses. After the shift from analog to digital, the two industries overlapped and became direct competitors, offering Internet service and distribution of entertainment content. Supply of TV entertainment became a joint effort between producers of content (comprising studios, cable TV channels and programming networks) and pay-TV distributors (pipe companies that own fixed line or wireless bandwidth over which content is delivered) that serviced the consumer.

Like Verizon, AT&T was a pipe company, and later, a content distributor. Its business was bandwidth — originally for voice calls, then for Internet service, and later for TV entertainment. The real “value” — the content — came from the content producers. But content firms needed to pipe their content into consumers’ homes. This made for a mutually beneficial pipe+content partnership. The pipe company was uniquely positioned to be the only distributor for carrying TV programming, so it could monetize its pipe by charging for content.

Several things — the Internet, mobile networks, over-the-top (OTT) distribution, and digitization of entertainment content — have upset this cozy relationship. Today, consumers can get content through many other content bundlers — Netflix, Hulu, Hulu Plus, Amazon Video, iTunes, Google Play etc. — or even directly from specific networks or channels such as CBS or HBO. While the content still flows through the pipe company’s infrastructure, these new bundlers are the ones that capture consumers’ content dollars.

This decoupling between pipe and content bundling has shifted revenue away from the pipe company. Worse, as consumers shift to more bandwidth-heavy content such as video, online games, and virtual reality, the pipe companies have to spend more and more on infrastructure. Market pressures make it harder to keep increasing monthly fees, and regulations prevent the pipe company from charging differentially for bits representing content from other bundlers. Things will get worse for them once consumers get even more “pipes” after ultra-fast 5G mobile networks become common.

What is the pipe company to do? It cannot stop other firms from content bundling, but it can capture consumers’ content dollars by owning content.

Changes in the Economics of Bundling

The TV entertainment industry has relied on bundling or aggregation as the primary way consumers pay for content (i.e., you pay for packages comprising dozens or scores of channels, with content sourced from multiple producers). Content is produced by a wide swath of artists, studios and programming networks. It is then aggregated into bundles by distribution companies, the pipe-owners such as AT&T and Verizon.

Bundling is a powerful and profitable competitive strategy when a firm can bundle its own products (e.g., a Microsoft Office bundle, or a fast food bundle of burgers and fries). It works especially when individual goods have low unit variable costs. But, as my research shows (Retailer-Driven Product Bundling in a Distribution Channel, 2012 Marketing Science), the economics of bundling become unattractive when the retailer has to source products from multiple producers. In an illustration of this “tragedy of commons” principle, producers demand excessively high carriage fees when their content hides inside a bundle, raising the retailer’s variable costs, and pushing the model away from bundling and towards à la carte pricing.

This economic tension around bundling has simmered under the surface for several years, and occasionally becomes public in the form of carriage fee disputes between producers and pipes. It has become more salient now that the distributor has lost monopoly power and faces competition from numerous over-the-top bundlers. Competition weakens the distributor’s hand in negotiating with content producers. Less bundling and higher marginal costs mean less profit for the pipe company. On top of this, the pipe company may even lose consumers who move to over-the-top bundlers. Once again, the answer lies in moving up the business channel into production or ownership of content. Netflix and Amazon made this move five years ago, and the pipe owners are doing the same now.

Defense vs. Offense

The above argument for vertical integration may be viewed as a defensive move by AT&T, a reaction to loss of content distribution revenues to OTT distributors. But there is potentially an offensive element as well. Entertainment consumption has shifted substantially to mobile devices, and that share is still increasing. Mobile consumers pay more as they use up more bandwidth. AT&T could choose to not count consumption of AT&T content towards the user’s data cap (this is called “zero rating”). This would make it more attractive for AT&T users to stick with AT&T content, and increase of AT&T content consumption would fetch AT&T higher advertising revenues. However, while zero rating has been practiced by T-Mobile (BingeOn) and AT&T (for DirecTV content), its legality is questionable with respect to net neutrality regulations.

What does the Future Look Like?

In the old model where production and distribution roles were separated, each distributor provided access to all of the television entertainment content. Consumers simply needed to pick the level of bundle that fit their tastes. The foreseeable future, and some would say present, is quite different, with “walled-garden” competition between multiple vertically integrated “systems” that combine pipe and content either through ownership or exclusive production deals. Nelson Granados and I discussed this in a Forbes.com article last year (Using Analytics To Predict The Future Of TV Content And Distribution).

This new model would no longer provide a one-stop shop for access to all content, and consumers would be forced to pay at multiple places for their content. Because content consumption leads to advertising revenue, each integrated player will prefer to put its own content in front of its Internet consumers. Premium content owners that are independent of the vertically integrated players will be targeted for exclusive deals or acquisition. But not all will get sucked in because these gardens will have porous walls. Premium content providers will seek to reach consumers directed through Internet streaming, or reach them via content bundles managed by over-the-top aggregators such as Netflix or Amazon.

The vertical systems will also need to decide whether to make their most high-value programming available to competing systems. Here, the emergence of exclusivity is not guaranteed. For a premier channel such as HBO, AT&T would need to trade off the benefit of exclusivity (competitive advantage in the pipe industry) against its cost (lost content revenue from cutting off consumers of Verizon and other pipes). With vertical integration, pipe+content systems are not merely each other’s rivals or enemies, they are also partners whose user bases provide revenue opportunities for each other’s content. This is an issue that has been studied in platform competition (see Frenemies in Platform Markets: The Case of Apple’s iPad vs. Amazon’s Kindle). As Yogi Berra put it, “It’s like déjà vu all over again.”