March 15, 2002
From the desk of Jane Galt:Steven Den Beste analyzes the
Steven Den Beste analyzes the Barcelona summit on European integration by comparing the EU to a corporate merger and asking whether it's likely to cause growth.
It's an interesting question, though I think there's a question that bears on this one that Steven doesn't ask directly: what makes a merger successful?
The classic answer is "synergies", which in my experience is a weasel word that means "I'm not quite sure, but this is the amount we need to hit the EPS numbers that will make this deal sell on the street." Call me cynical. The AOL/Time Warner deal, which was supposed to create the amazing synergies by vertically integrating content, network, and access points, has yet to create shareholder value. As Den Beste points out, glomming two big companies with problems together by itself just creates a bigger company with bigger problems.
The idea that the AOL/Time Warner merger was a terrific idea was based on a flawed conception of what creates value in a merger. The story on the street was that ownership of the cable assets and the content would allow AOL to dominate the internet market, while AOL would be a massive promotion/distribution venue for Time Warner's assets. But it's hard to see what the merger accomplished that couldn't have been done much more cheaply with a distribution agreement. The problem with trying to up your shareholder value by purchasing a scarce asset (like Time Warner's near-monopoly cable network) is that whoever owns the asset charges full price for it. It's an economically neutral transaction, neither creating nor destroying value; it just transfers money from place to place. In order for such a transaction to create value, AOL would have to be better able to use the assets than Time Warner -- but since AOL had no particular expertise in managing cable infrastructure, there was no reason to think that the transfer would create value.
The other common fallacy is that it's somehow a moneymaking proposition for AOL to give Time Warner advertising, or for Time Warner to give AOL exclusive use of its assets. This comes from not fully pricing the cost to the company of giving away goods or services to other parts of the company. Let's say that I own an ice cream machine and you have a waffle-cone maker. We merge, and you start giving me waffle cones in which to sell my ice cream. I save the 10 cents it used to cost me for each cup to put the ice cream in, and I can charge 15 cents more for the resulting ice cream cones. Simple accounting shows this as a 25 cent increase in profits.
What this leaves out an important economic concept called opportunity costs. The opportunity cost of a project is the income from the next best alternative use of the resources necessary to complete the project. If you have a choice between two jobs, one at $100,000 and one at $125,000, and you take the higher-paying job, your opportunity cost is the $100,000 you could have been making at the job you didn't take. When opportunity costs exceed the income from the project, it's a bad investment of time and resources.
In this case, let's say that if you weren't giving them to me, you could sell your waffle cones to my competitor across the street for 30 cents. Suddenly the merger doesn't create value -- it destroys it. This is essentially what people were suggesting AOL/Time Warner could do -- hand over valuable resources, like advertising space or exclusive use of the cable assets -- to each other at less than they would sell them on the market. In fact, mergers encourage such behavior all the time, which is why over the long run they tend to destroy shareholder value.
There are two classic ways in which economists believe mergers can create value: redundancy, and co-specialized assets. The first is easy to understand. Say that, instead of a waffle cone maker, you also own an ice cream machine. In order to compete, we spend aggressively on advertising, signs, and the like. We also both have to be on our corner all day every day. If we consolidated, one of us could cover the store some days, the other the rest of the time. We could have one nicer sign. We could save money on milk by buying in bulk. Perhaps we could get rid of one expensive-to-maintain machine and just use the other. Such savings are called economies of scale, and while I have made them very simple in this example, the basic idea is that there is a profit-maximizing size for any given type of firm, and a merger of two like companies can produce value by achieving that size. This is the argument behind the HP/Compaq merger.
The other way that mergers create value is by merging firms that have prohibitively high transaction costs preventing them from making otherwise profitable deals. A transaction cost is any monetary or non-monetary cost, aside from the price, associated with making a deal. The amount of time you spend looking for a house is a transaction cost, as is the broker fee, the lawyer fee, the escrow fee, the filing fee. . . you get the idea. The price of the house you buy is not a transaction cost.
The most common transaction cost preventing otherwise profitable deals is something known as highly co-specialized assets. Consider the waffle cone maker. Suppose I come out with a bubble-gum flavored ice cream, and I want you to make a novelty cone in the shape of a bubble. I can sell this cone for $3.00 instead of $1.50 at little extra cost to me. However, for you to do this, you'll have to completely retrofit your waffle-cone maker. It won't be good for making anything except bubble-gum shaped cones. If the cone doesn't take off, or I get sick of bubble gum, or someone famous dies a horrible bubble-gum related death that kills the cone's popularity, you're stuck with an expensive cone-maker that's not good for anything. Moreover, since I know this, once you've done the retrofit, I might decide to tell you that my new price for bubble-gum shaped waffle cones is 5 cents -- take it or leave it. Since leaving it would mean going out of business, you're at my mercy as soon as you commit to the transaction. In this case, merging makes sense; I get my bubble-shaped cones, and you get a guaranteed share of the profits.
Whew! Hang in there . . . we're coming to the home stretch.
So let's look at the EU "merger". Is there redundancy? Absolutely. Tons of it. But over half the French population is employed by the government -- think they're going to initiate massive cutbacks? The "merger" is introducing another layer of redundancy, not removing it.
How about transaction costs? Well, here we hit the mother load, in the form of national differences that restrict the flow of capital and labor between countries. I'm talking of work restrictions and the like, of course, but I'm also talking about regulations not intended to restrict the flow, which nonetheless have that effect. Small differences in the tax code, for example, increase the cost of moving capital because you have to learn what the differences are before you can invest. The largest of these barriers -- language -- probably won't be resolved soon. But the second largest, currency, just got taken down. This is huge. Companies or individuals wishing to invest abroad no longer have to factor currency risk into their calculations. It also allows for increased competition between countries, which is always good for the world economy -- but there's the rub.
There's a third reason to merge, of course, and that's the hope that you can get rid of competition. If the two companies merging control enough of the market, there's the hope (on their part, not ours) that they can lock up a monopoly or near-monopoly and get fat and sloppy while raising prices and providing indifferent products. When it's two companies trying to do this, the FTC or its European equivalent screams like a banshee. When it's governments, obviously, there's no such restraint.
So it really depends on how the merger is implemented, and whether lowering transaction costs or restraining competition becomes its prime driver -- something which very much remains to be seen.
Posted by Jane Galt at March 15, 2002 02:38 PM | TrackBack | Technorati inbound links