The Moguls’ New Clothes

Image credit: John Cuneo

Time Warner announced in May that it plans to spin off its AOL division by year end. The new AOL’s value will likely be barely 1 percent of the market price of the inflated stock that Time Warner accepted in the original $175 billion merger almost a decade ago—despite the inclusion of numerous subsequent expensive add-on acquisitions. While extreme, the Time Warner–AOL combination was no aberration. The deal represents less than half the financial damage done during an unprecedented era of excess in the media business. Since 2000, the largest media conglomerates have collectively written down more than $200 billion in assets, a record that would make even Citigroup blush. These write-downs reflect a broad-based legacy of value destruction from relentlessly overpriced acquisitions, “strategic” investments, and contracts for content and talent.

One might be tempted to give media executives a pass because of the impact of the Internet. If we take Netscape’s public offering in 1995 as the birth of the Internet era, on average over the next 10 years the biggest media conglomerates achieved less than a third of the returns available from the S&P as a whole. But even more telling is that these companies, as a group, had also underperformed the S&P for much of the previous decade, before the Internet upended their industry. Indeed, one aspect of the media business has remained largely unchanged for a generation: the lousy performance of its leading companies.

Although individual media moguls have come in for skepticism and scrutiny, the industry’s underlying strategies have mostly escaped question. Executives, investors, analysts, and the press seem to agree that the primary imperatives are to accelerate growth, diversify internationally, invest in content, and exploit digital convergence. Unfortunately, these are precisely the strategies that media companies pursued aggressively during the past lackluster decade.

Understanding the fundamental flaws of these four tenets of conventional media wisdom—growth, globalization, content, and convergence—is essential to saving media shareholders of the future from the anemic returns of their predecessors. Each myth reflects its own confusion about the sources of competitive advantage. Indeed, media executives have been remarkably successful at convincing outsiders that this sector, possibly because of its reliance on mysterious creative factors, is somehow governed by unique business principles. Unless tomorrow’s media moguls jettison these beliefs and return to sound business practices, their companies will remain unable to achieve the kind of returns investors can get by closing their eyes and throwing a dart at the stock tables.

Like many corporate chieftains, media executives worship growth. But all “good” things, including growth, come at a cost. In this case, that cost comes in the form of the investment needed to generate growth—whether internally or through acquisitions. When its cost is greater than its return, growth—every incremental dollar of it—actually destroys value.

Comparing the revenue growth over time of the largest media conglomerates with their respective share performances reveals a remarkable fact: a strong correlation indeed exists between revenue growth and shareholder-value creation—but it is decidedly negative. In other words, the faster revenue has grown in these companies, the worse their stock has performed. Although counterintuitive, this makes perfect sense if that growth was achieved through bad investments.

Media is the only economic sector that historically has achieved growth predominantly through mergers and acquisitions. The sheer number of transactions, as well as their later impact on share prices, raises the suspicion that they are driven by an almost blind eagerness—a suspicion reinforced by a cursory look at the biggest such deals. Some, like Time Warner’s merger with AOL or Viacom’s $40 billion combination with CBS, suffered from fundamental incoherence and have since been undone. Others, however, like Comcast’s $75 billion acquisition of AT&T’s broadband business, were strategically sound and flawlessly executed. But a closer analysis suggests that even these transactions were concluded at a price that made positive net returns almost impossible.

Investing to grow bad businesses is as destructive as making bad acquisitions. Movies have attracted significant investment, driving a long-term organic growth rate that is among the fastest in media. For all the complaints about piracy, the sector has enjoyed new revenue streams from VCRs and DVDs, proliferating cable channels and distribution, video on demand, and overseas markets. Churning out more and more movies distributed through more and more avenues, the industry generated compounded annual revenue growth of 8.5 percent over the 20 years beginning in 1980. But costs grew at a compound rate of more than 11 percent annually, so for every dollar of new revenue, shareholders were actually worse off.

Investing for growth in businesses creates value only when barriers to entry—which is just another way to say “competitive advantage”—limit the competition that would destroy favorable returns. Without barriers to entry, such investments, no matter how fun, sexy, or otherwise hot at the moment, may provide psychic benefits for executives, but only heartache for shareholders.