The Merger That Defines The Streaming Wars: How Discovery Merging With Warner Media Illuminates the Key Schism in the Entertainment Industry

What a time to be alive and writing a column on the business of entertainment. I get back from vacation, and not only do I get a mega Hollywood divorce, but I get a mega Hollywood marriage. In the same story! This deal—AT&T selling Warner Media to Discovery—has me bursting with thoughts. 

As you’ll likely read in another outlet this week, I’m not a huge fan of “mergers & acquisitions” (M&A) in general. The main reason is strategic: most M&A isn’t really done to reinforce a sound business strategy, but simply to merge for mergers sake. M&A often isn’t good strategy, it is action in place of strategy. 

(And in journalism is anything less reliable than M&A rumors? Probably NBA trade rumors and new Presidency potential cabinet nominees, but that’s about it.)

Pondering this deal while on a beach last week, I sort of love it. Again, not because I’m convinced it is a great deal—we’ll see—but because this deal represents the streaming wars so well. Everything from failed mergers by traditional firms to the influence of big tech to the disruption of streaming…it’s all there. 

This may not be the M&A deal we wanted—or anyone predicted—but its the M&A deal the streaming wars deserve. The streaming wars are mostly about the battle between tech on one side and traditional firms on the other. This leads to all sorts of dualities and contradictions. This deal represents all that. And that’s the theme of the day.

(We’ll still have a lot to cover on who won and lost this deal, how it impacts all the other players and other potential M&A, but that will have to wait for future articles. I promise this won’t be the last time I write about this deal.)

Duality 1: Mergers are great strategy unless they aren’t.

What’s the old joke about the lottery? I have a fifty-fifty chance of winning: either I will win or not. Those are good odds!

Funnily enough, that’s actually the math I was taught on M&A in business school. About half the time, mergers work and about half the time they don’t. In this case, flipping a coin is a good rule of thumb.

It does depend on what one means by “work”, though. Good deals—especially young tech acquisitions—tend to have huge upside. Think Google buying Youtube for only $1.6 billion. Youtube is on track to make $25 billion in revenue this year. So yeah, that was dirt cheap. Same for Facebook buying Instagram. Those are the type of deals that keep would-be moguls always searching for the next acquisition.

Of course, the misses can be equally big in M&A. Think AOL and Time-Warner. DirecTV and AT&T. Sony and Columbia/Tri-Star. Companies spending tens of billions, only to write it all off later. 

Keep this in mind for all the strategic evaluation for the new Discovery-Warner Media deal and all the postmortems on AT&T’s acquisitions. It seems like for all the fancy models we could make, about half the time it works out—Disney buying its brands the last decade, like Marvel, Lucasfilm, BAMTech and Pixar—and half the time it doesn’t—Time Warner to everyone.

Duality 2: Is M&A dying or booming?

Following the Time Warner-AT&T approval in 2018, everyone forecast a “tsunami” of M&A. That tsunami never really arrived. (Read my take here.) Through 2019, M&A activity had been steady as ever. But then in 2020 Democrats and Republicans seemingly united around hatred of Big Tech. I’ve called this potentially the biggest change to the strategic landscape in the last few years.

But then we have this huge deal! What’s going on? M&A is dead, but it won’t lie down.

In this case, the “tech vs non-tech” divide basically explains the contradiction. For Big Tech—especially the big four of Apple, Amazon, Google and Facebook—new acquisitions probably are dead. If Amazon tried to buy Warner Media, the Department of Justice would take a long look. Tons of politicians would weigh in and demand it get stopped.

Discovery just isn’t in the same league. It is two orders of magnitude smaller than Amazon by market capitalization. ($15 billion to $1.5 trillion, roughly.) For a plain old entertainment company like Discovery, regulators probably won’t particularly care if it buys Warner Media.

That’s the contradiction of M&A: if you’re a big tech company, you’re probably on notice that you can’t buy anyone. If you’re not Big Tech, you’re probably fine. 

Duality 3: Does “Content” Help with Vertical Integrations?

Comcast, AT&T, Amazon and Apple have some strong similarities. They all have dominant positions—either oligopolies or monopolies—in one or more industries. These generate huge cash flows that need to be put to use. They all sell subscriptions. 

And in the 2010s, they all got into the content business.

The reason was the same too: having buzzy and free content would help sell more subscriptions. The differences are equally large, though. Apple and Amazon built their own streaming services from scratch, whereas Comcast and AT&T bought established companies. And while the former are valued like tech companies, Comcast and AT&T are boring old communications companies. And with plenty of debt from all their buying.

This does leave this enticing question: For all the investment in content by those four companies, has it worked? For any of them?

If we’re talking hard numbers—subscribers, revenue, operating profit—we basically have no idea. Yes, they’ve all provided hints, rumors or leaks saying, “It is going great!” But that isn’t proof. So when it comes to the perception success, the general consensus seems to be that AT&T was failing, whereas Apple and Amazon are probably succeeding. But no one knows. When in doubt, assume the cable company and telco are probably wasting money, but assume that Apple and Amazon are not. Again, tech vs non-tech.

Contrariwise, my gut is the strategy has probably worked about the same for all four companies. Content is fine, but doesn’t actually drive that many subscriptions. Because it is mostly interchangeable.

The difference is one of perception. In this case, it pays to be Big Tech. Or more precisely, only Big Tech can pull off this maneuver, because they are so large that spending tens of billion on content just doesn’t impact their cash flow much. So no one notices. Even as big as Comcast and AT&T are, they aren’t quite that large (or highly valued) and they have debt to pay off. Since they both acquired huge studios–among other assets—they had to take a lot of debt on to get into the content game. That matters.

Duality 4: Do Subscription-Only Business Models work or not?

My favorite part of this deal is what it says about the biggest story of last December, AT&T’s decision to take Warner Bros movies straight to HBO Max. This was supposed to be the move that took HBO Max from “nice to have” to “must have”. And yet, clearly it failed. Why else would AT&T be so willingly to cut their losses?

And yet, this same strategy allegedly works wonders for Netflix, with their globally day-and-date released films. Again the contradiction couldn’t be more stark.

Again, different perceptions between “tech” and “traditional” media. Netflix can lose money, and they’re still fine. For all the hype about cash flows, Netflix still hasn’t actually made money in free cash flow terms for a full, non-Covid calendar year. Think about that. AT&T, on the other hand, needs to make money to pay back the acquisition costs of Warner Media. And Wall Street insists they do, with a dividend to boot. AT&T thought they could sprinkle “subscription magic” on HBO Max and release all their films directly, just like Netflix. They assumed this would pay for itself multiple times over.

They were wrong. 

And this isn’t because their content is bad. Sure, Warner Bros doesn’t have as strong a slate as Disney or Universal in feature films this year, but I’d take their slate over Netflix’s film slate, except for maybe Army of the Dead and Red Notice. The problem is theatrical releases just made so much more money. Subscription-only release strategies are great…if you’re Netflix. For everyone else, the math just doesn’t work.

Conclusion: Big Tech Is Evaluated by Wall Street Differently, But the Rules Haven’t Changed

Whenever I bring up Big Tech, including Netflix, inevitably, someone pulls out the phrase, “They’re playing by a different set of rules.” I hate that phrase. 

Because economics and business strategy have the same core principles. A stock price is still the discounted future cash flows of a company. Different analysts can have different opinions on a company’s growth prospects, but the math of business is the math. Math doesn’t change.

But does the perception of the math change? Obviously. Which is why the stock market is supremely rational and irrational at the same time. 

And right now Big Tech (which includes Netflix in streaming) is perceived to have better growth than everyone else. And thus they’re afforded different leeway from Wall Street.

Which is fine. It’s neither good nor bad, but the reality business leaders need to manage. It is a constraint traditional entertainment has to deal with. Disney has mostly convinced Wall Street that they’re a tech company too. ViacomCBS and Discovery convinced one over-leveraged investor (Archegos Capital) they had pivoted too.  

AT&T had failed to change Wall Street’s mind. So AT&T cut bait on streaming.

The Bottom Line: Discovery Thinks That This Deal Will Make Them a Streamer

Thus far, I haven’t actually mentioned whether or not I like this deal for Discovery. To be honest, I don’t know yet. I’m still thinking through all the pieces and running my own numbers.

But I have to say I like the logic. Instead of pairing two dissimilar businesses—cellular and entertainment—you have an even larger entertainment company. One that can be focused on streaming. With two potentially successful streaming services, if not more. Which means it is even easier to convince Wall Street that the’ve gone “all in” on streaming. (Though yeah I hate that phrase, “all in” too.)

The downside? Unlike Disney, Apple, Amazon, Google and Comcast, this new entity doesn’t have some rich stream of free cash flow to tap into. So the trade is focus—streaming—and the cost is a giant pool of money to tap into.

If Discovery can convince Wall Street it is the new Disney/Netflix, and raise their valuation accordingly, it’s not a bad strategy.

I’d give the odds at 50/50.

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