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Press Release

    Issue Analysis 91 - Understanding the Urge to Merge in the Telecommunications Industry

    05/20/1999

    The past several years have seen several large telecommunications mergers announced and consummated in the United States. Bell Atlantic merged with NYNEX and now seeks to acquire GTE. SBC merged with Pacific Telesis and Southern New England Telephone, and now wants to merge with Ameritech. Long-distance firms also contribute to the trend. WorldCom acquired MCI. AT&T acquired TCI and now plans to buy MediaOne Group so it can offer local telephone service over the cable company’s wires.

    Why are these mergers happening? There are four potential explanations: monopoly, managerial discretion, cost efficiencies, and strategic restructuring. Little evidence supports the monopoly and managerial explanations. A great deal of evidence shows that the mergers are motivated both by cost efficiencies and by strategic restructuring.

    Monopoly

    A firm has "market power" when it possesses the ability to sustain a significant price increase for a substantial period of time. This normally occurs when there is little actual competition and potential competitors find it difficult to enter the market. There are three ways in which telecommunications mergers might create market power: displacing existing competition, displacing potential competition, or allowing a monopolist to extend its monopoly into new markets. There is little evidence that the current spate of telecommunications mergers will do any of these things.

    Displacing actual competition

    The mergers at issue rarely involve companies that currently compete with each other. Many are mergers of local telephone companies that until recently enjoyed government-protected monopolies, and these firms have not yet begun entering each other’s markets. Other mergers, such as AT&T and TCI, involve companies in businesses that regulation has historically kept separate.

    A few mergers involve firms that compete with each other in a few markets. WorldCom and MCI are two of the nation’s largest long-distance carriers, and while WorldCom did not serve residential customers, the two companies both served business customers. However, the Federal Communications Commission (FCC) concluded that there would be little threat to competition here because four firms in addition to the largest four long-distance carriers are building national fiber optic networks, which vastly expands the amount of capacity available in the long-distance market that would not be owned by MCI-WorldCom.1

    In several other cases, regulatory rules or stipulations have prevented any possible reduction in competition. The wireless divisions of companies such as SBC and Ameritech compete in some cities, but FCC rules require the merging firms to divest one of the competing wireless properties in each location.2 The MCI-WorldCom deal also involved two of the largest providers of Internet backbone service, but both European and American regulators required MCI to transfer its Internet assets and employees to a British company, Cable & Wireless, for $1.75 billion. FCC Commissioner Harold Furtchgott-Roth pointed out that it is not clear whether this divestiture was really necessary to protect competition; letting a European company pick up some Internet assets at a fire sale price may simply have been a concession extracted by the European Community to win its approval of the merger.3

    Displacing potential competition

    The FCC believes that the 1996 Telecommunications Act requires it to actively encourage the development of competition. For this reason, the Commission examines whether a merger eliminates an independent firm that would have competed with its merger partner were it not for the merger. This issue usually arises in mergers involving local telephone companies:

    In the SBC-Pacific Telesis case, the FCC found that the other Bell operating companies, AT&T/TCI, Sprint, MCI, LDDS, Cable & Wireless, and Time Warner were all potential competitors, and the two merging companies had no plans to compete with each other.4
    In the Bell Atlantic-NYNEX case, the FCC found a smaller number of potential competitors in the local markets of concern: New York City and northern New Jersey. The FCC looked for companies that had not only relevant expertise, but also established brand names and assets already in place in these markets. This left Sprint, AT&T, and MCI, in addition to Bell Atlantic and NYNEX. Clinching the determination was the fact that Bell Atlantic had, prior to the merger, made plans to enter the New York City market. As a result, the FCC imposed a number of requirements designed to make it easier for new firms to enter the New York City and northern New Jersey markets by using parts of Bell Atlantic-NYNEX’s facilities.5
    The SBC-Ameritech merger should pose little threat to potential competition. The only area in their territories that is conceivably analogous to New York City-northern New Jersey is St. Louis (served by SBC) and East St. Louis (served by Ameritech). Geography suggests that two other Baby Bells, US West and Bell South, could also be potential entrants here. In addition, the companies had no plans to compete with each other in local wireline service. SBC explored the possibility of offering local telephone service outside of its region, but market trials proved disappointing, and the company decided to focus its attention elsewhere.6 Ameritech tried reselling local service bundled with cellular service in St. Louis, but it had little success and put the project on hold.7
    Bell Atlantic and GTE have some adjoining franchise areas in Pennsylvania and Virginia. GTE has no plans to enter Bell Atlantic’s territories, even as a reseller, except to serve facilities of a few customers with major operations in GTE territories. Bell Atlantic once considered entering some of GTE’s territories with a combination of local and long-distance service, but experiments with offering out-of-region long-distance service in North Carolina prompted the company to reject this possibility.
    Because potential competition is competition that has not yet happened, analysis in this area can be fuzzy and arbitrary. To decide whether companies are potential competitors, the FCC asks whether they have "equivalent" capabilities, whether one planned to enter the other’s market, and whether the entrant would have had a substantial likelihood of succeeding. In truth, individuals who are best qualified to answer such questions are most likely running telecommunications companies, not regulatory agencies.

    Extending monopoly into new markets

    A final fear, usually raised by competitors of the merging companies, is that the merged firm will have an enhanced ability to extend or "leverage" its monopoly into new markets. This concern surfaces in deals involving services that historically enjoyed government protection from competition, such as local telephone and cable TV service.

    It is true that firms with regulated monopolies may have incentives and opportunities to monopolize other, competitive markets that they enter. But none of the mergers increases any firm’s ability to do this. Two local telephone companies who merge will have the same incentives and ability to leverage their monopolies as they had if they did not merge. Similarly, a cable TV company like TCI has the same ability or lack of ability to monopolize other markets whether it merges with AT&T or enters new markets on its own.

    Evidence from stock prices

    The circumstances of these mergers suggest that they pose no threat to competition, either because there is inherently no threat or because existing regulation exorcises any potential for monopolization. In addition, financial market data show that the mergers will enhance rather than retard competition.

    If a merger increases competition, then the stock prices of the merged firms’ competitors should fall when the merger is announced. If a merger reduces competition, the stock prices of companies that compete with the merging companies should rise, because they will have an opportunity to earn higher profits in a less competitive market. An analysis performed by Thomas Hazlett, a professor at the University of California, Davis, reveals that three of the most controversial mergers generally reduced the stock prices of companies that are actual or potential competitors of the merged firms. For this reason, he concluded that the Bell Atlantic-GTE, AT&T-TCI, and SBC-Ameritech mergers can all be expected to increase competition.8

    Managerial Discretion

    Two different explanations of mergers are based on managerial discretion. The first suggests that inefficient mergers occur because managers engage in personal empire building, even though this activity harms shareholders and does little or nothing to benefit consumers. The second suggests that mergers are a means of replacing a less competent management team with a more competent one; in this case, mergers benefit both shareholders and consumers.9 Neither theory helps explain recent telecommunications mergers.

    Managerial empire-building

    The telltale sign of unproductive empire building is a hodgepodge of acquisitions accompanied by vague managerial claims about "diversification." This is precisely the opposite of what is happening in telecommunications. With one exception, none of the firms involved have offered diversification as a justification for their mergers.10 In fact, all of the firms appear to be following similar, focused strategies that would allow them to offer an array of telecommunications services to customers worldwide. There is no guarantee that this strategy will succeed, but investors have generally rewarded the merger announcements with increases in the share prices of the merging companies. This result suggests that shareholders see the mergers as sensible moves rather than senseless empire building.

    Replacement of less competent management

    There is also little evidence that the telecommunications mergers aim to replace less competent managers. Mergers that replace less competent managers usually do so over the objections of those managers, and so they take the form of hostile takeovers. A lot of this type of activity occurred in the 1980s, when various hostile takeovers undid many of the mistaken conglomerate mergers of the 1960s. Contemporary telecommunications mergers, however, do not involve hostile takeovers.

    Cost Efficiencies

    All of the merging firms argue that they will enjoy large cost efficiencies as a result of the mergers. Claims that these mergers will give firms better access to capital should be viewed with suspicion, but there is substantial evidence that other types of cost efficiencies will lead to significant consumer benefits.

    Access to capital

    One cost justification for the mergers can probably be dismissed: the idea that they give the merged firms better or lower-cost access to capital than they would otherwise have. TCI, one of the nation’s largest cable television companies with wires passing 21 million homes, argues that it cannot by itself raise the capital needed to enter local telephone service. SBC and Ameritech plan to begin offering phone service in 30 cities outside of their current territories, and they claim neither company could by itself sustain the "earnings dilution" that would result if they borrowed the billions of dollars needed for this venture.11

    It is difficult to believe that such large companies would truly have difficulty raising capital in the most efficient capital markets in the world – as long as their expansion strategies are actually sound. Issuing large amounts of debt would likely dilute their earnings, which might make their stock less attractive to traditional telephone company investors who are willing to accept modest growth in exchange for secure dividends that are larger than those offered by most other companies. But this merely means that conservative, dividend-oriented investors would sell their stock to growth-oriented investors who are willing to give up current dividends in exchange for greater growth in the future.12

    Cost reductions

    A large body of evidence shows that the mergers are nevertheless motivated by the prospect of substantial cost reductions:

    Bell Atlantic and GTE expect that their merger will save $2.5 billion annually.13
    The actual amount of cost savings projected in the Bell Atlantic/NYNEX merger is not public knowledge, as they are detailed in confidential documents filed with the FCC. But the companies report that they are well on target to achieve those savings.14
    SBC and Ameritech project annual cost savings of $1.17 billion in expenses and $230 million in capital costs.15
    SBC reports that its cost-saving efforts resulting from the Pacific Telesis merger are ahead of schedule.16
    AT&T and TCI expect to save money on marketing by selling telephone and cable TV service to each others’ customers, and local telephone traffic generated by TCI can be routed over AT&T’s switching and transport facilities, spreading fixed costs over more lines and services.17
    These cost reductions come from two main sources: economies of scale and scope, and sharing of best practices.

    Economies of scale and scope are familiar concepts used in antitrust analysis of competition. The basic idea is to reduce the cost of each service or unit of service by using equipment and systems more intensively. When the fixed costs of equipment and systems are spread out over more customers or services, the company can charge less and still make a profit. The merged companies hope to accomplish this by spreading the costs of facilities, equipment, software, billing systems, advertising, and administrative functions over a larger base of customers buying multiple services.

    The effects of best practices receive little attention in antitrust and regulatory analysis, but they are a potent force for cost savings and sales increases. Different companies are good at different things, and mergers facilitate the transfer of knowledge and expertise across companies. SBC and Ameritech, for example, project that they will save $131 million annually due to the spread of best practices across the two companies.18

    Will consumers benefit?

    Merger skeptics frequently question whether consumers will benefit from the cost efficiencies. Such critics, still thinking of telecommunications firms as absolute monopolies, often argue that firms should be required to pass through some of the cost efficiencies as guaranteed consumer savings. Such requirements are unnecessary, for several reasons.

    First, as the FCC recognized in its discussion of the NYNEX-Bell Atlantic merger, even a telecommunications firm with a monopoly has an incentive to share some of its cost savings with consumers.19 When a merger reduces a firm’s marginal costs – the additional cost of producing a little more service – the firm profits by reducing its price in order to sell more of the service.

    Second, many local phone companies have already committed to sharing their cost savings with consumers, because they are subject to various forms of "incentive" regulation at the local level. Local telephone companies in more than 30 states are currently subject to price caps, rate freezes, earnings sharing, or other forms of regulation that induce them to reduce costs and share the benefits with customers.20 In some cases, the firm shares future cost savings with customers; in other cases, it gives customers rate reductions or other rate guarantees up front in exchange for the opportunity to profit from any cost reductions it might achieve in the future. Because mergers are a powerful means of reducing costs, they help make it possible for firms to deliver these consumer benefits.

    Finally, an increasingly competitive telecommunications marketplace will force firms to pass their cost savings on to consumers, regardless of what regulators do. Many of the recently proposed mergers are part of companies’ larger strategies to compete aggressively in offering local telephone service. SBC and Ameritech plan to enter the 30 largest local markets outside of their territories.21 Bell Atlantic and GTE plan to enter 21 major urban markets in other Baby Bells’ regions within 18 months of their merger.22 AT&T is buying TCI so it can use cable television lines to offer local phone service. Faced with such competitive pressures, the merging firms and their competitors will have little choice but to pass a substantial amount of their cost savings through to consumers.

    Strategic Restructuring

    But there is more to the merger story than mere cost savings. The mergers are also motivated by an urgent need to restructure the telecommunications marketplace in ways that differ significantly from the structure enforced by decades of regulation.

    Four significant economic trends are driving changes in the telecommunications industry:

    National and global markets. A growing number of companies, especially businesses, want to be able to contract with a single telecommunications provider to supply most of their needs, across the nation and around the globe. A single supplier helps ensure that systems in different locations are similar, or at least compatible, and also ensures that one company can be held accountable for service problems. As a result, telecommunications companies increasingly find a need to offer service on a national or even global level. The old regulatory structure hampered this development by dividing local markets among different companies.
    Technological convergence. The convergence of computers, telecommunications, and video means that voice, video and data can all be sent using the same wires and equipment. Telecommunications firms seek to respond to this change by offering "one-stop shopping" for all of these services. The old regulatory structure stood in the way of this change by fragmenting service offerings among different types of companies – local telephone, long-distance telephone, cable TV, and Internet access.

    Mind work and ubiquitous communication. The distinction between residential and business markets is itself blurring because the growth of "mind work" has facilitated an expansion in telecommuting. The most recent survey by FIND/SVP shows that approximately 11 million Americans telecommuted in 1997, up from 8.5 million in 1995 and 9.7 million in 1996. Telecommuting has grown at an average annual rate of 15 percent over the past two years.23 Jack Nilles, the former professor and consultant who invented the term "telecommuting," projects that 24.7 million employees – 18 percent of the workforce – will telecommute by the year 2000, and 30 million will do so by the year 2005.24 When telecommunications provide the crucial link to let people use their homes extensively for business, the regulatory distinction between "business" and "residential" customers makes less sense, as do all the elaborate cross-subsidy schemes based on this increasingly artificial distinction.

    Continuous innovation and customer impatience. During the past two decades, industries that have been deregulated or were never subject to economic regulation have set new standards for producing products and services better, faster, and cheaper.25 Businesses that must function in this competitive environment need telecommunications providers who can continually innovate and respond quickly to their changing needs. Consumers who have become accustomed to improved service and responsiveness in other contexts will no longer accept sluggish performance from regulated telecommunications companies. Unfortunately, telecommunications mergers that will create the capabilities to accommodate these demands face lengthy delays and costly regulatory hurdles.

    How Regulation Conflicts With the Future Economic Trend Regulatory Impediment
    National and global markets Geographical service territories
    Convergence of computers, telecom, video Fragmented product offerings
    Mind work and ubiquitous communication "Business" vs. "Residential" fragmentation
    Continuous innovation and customer impatience Cumbersome, costly, and time-consuming review processes

    How Can Government Accomodate the New Realities?

    A better understanding of the forces driving telecommunications mergers suggests several ways in which regulators – primarily the FCC – can adjust to the new marketplace:

    Refrain from imposing unbundling requirements on new, facilities-based entrants into local telephone service. By definition, entrants with their own local wires or facilities are not monopolists in local telephone service, so there is no rationale for forcing them to unbundle. Some commenters, most notably Internet and on-line service providers, argue that AT&T/TCI will be a monopolist because souped-up cable will be a much wider and better "pipe" for sending data than ordinary phone wires. But even if cable proves itself far superior for these applications, the local phone companies will have to respond either by offering a better alternative of their own or cutting their prices to such an extent that consumers see phone wires as a good alternative to cable.
    Reduce or eliminate unbundling requirements for local telephone companies when they face substantial, facilities-based competitors. Local phone companies were required to unbundle because they possessed statutory monopolies. When the monopoly disappears, so does the rationale for mandating that they unbundle and sell network elements to their competitors.
    Cut the number and length of merger review processes. Major telecommunications mergers must now undergo scrutiny by the FCC, Department of Justice (DOJ), numerous state utility commissions, and, in some cases, local governments. The AT&T/TCI merger alone is subject to approval by two federal agencies, the European Commission, nine public utility commissions, and 970 local governments. These costly and duplicative proceedings are a bonanza for attorneys, but no bargain for consumers.

    Strengthen the evidentiary requirements to prove that merger partners are potential competitors. A step in this direction would be to require proof that one of the merger partners has already made significant investments that could not be used for any purpose other than entering the other firm’s market. Such a change would prevent regulators from blocking or imposing conditions on mergers that pose no threat to consumers, and it would bring a measure of certainty to highly subjective judgments.
    Replace the FCC’s amorphous "public interest" standard with an antitrust "consumer welfare" standard. This change would make it clear that the FCC’s job is to protect consumers by promoting competition, not by imposing unrelated and costly requirements on firms that consumers may not value.
    Conclusion

    There is little evidence that monopoly, unproductive empire building, or struggles to replace the incumbent management team motivate the recent wave of telecommunications mergers. The principal motivations are cost reduction and strategic restructuring, both of which can be expected to produce substantial consumer benefits.

    The reasons for strategic restructuring also point the way to necessary telecommunications regulatory reforms. Regulators and legislators should both remember that monopoly is the sole rationale for unbundling requirements; as facilities-based competition emerges, the need for unbundling lessens. In addition, several changes in telecommunications merger review policies are in order. Merger review processes should be fewer and shorter, the FCC should adopt more objective indicators to determine when merger partners are potential competitors, and the Commission’s vague "public interest" standard should be replaced with an antitrust "consumer welfare" standard.

    1Application of WorldCom, Inc. and MCI Communications Corporation, FCC Memorandum Opinion and Order, CC Docket No. 97-211, para. 38.

    2SBC-Ameritech Merger Application, CC Docket No. 98-141, p. 58.

    3FCC Memorandum Opinion and Order, CC Docket No. 97-211, para. 143-56, and the separate opinion of Commissioner Harold Furtchgott-Roth in this proceeding.

    4In Re Pacific Telesis and SBC Communications., FCC Memorandum Opinion and Order (Jan. 31, 1997), para. 24.

    5In the Application of NYNEX and Bell Atlantic, FCC Memorandum Opinion and Order (Aug. 14, 1997), para. 37-146, 180-200.

    6Affidavit of Stan Sigman, CC Docket 98-141.

    7Affidavits of Paul G. Osland and Robert Jason Weller, CC Docket 98-141, paras. 31-33.

    8Declaration by Thomas W. Hazlett, In the Matter of GTE and Bell Atlantic.

    9The economic theories underlying these explanations can be found in Adolf Berle and Gardiner Means, The Modern Corporation and Private Property (Harcourt, Brace, 1968) and Henry Manne, "Mergers and the Market for Corporate Control," American Economic Review (1965).

    10The exception is TCI, which told its shareholders that the merger with AT&T will provide revenue sources that are more diversified and less subject to regulatory whim than cable television revenues. See AT&T Proxy Statement/Prospectus on the Merger of AT&T and TCI (Jan. 8, 1999), p. 35.

    11SBC-Ameritech Merger Application, CC Docket 98-141, p. 51.

    12For a more detailed explanation, see Comments of CSE Foundation, In the Matter of Merger of SBC Communications Inc. and Ameritech Corporation, FCC CC Docket No. 98-141, pp. 11-13.

    13Declaration of Doreen Tobin, In the Matter of GTE and Bell Atlantic.

    14Declaration of Doreen Tobin, In the Matter of GTE and Bell Atlantic.

    15Affidavit of Martin A. Kaplan, CC Docket 98-141.

    16SBC Communications, Inc., 1998 Annual Report, p. 2.

    17AT&T Proxy Statement/Prospectus on the Merger of AT&T and TCI (Jan. 8, 1999), pp. 31-35.

    18Affidavit of Martin A. Kaplan, CC Docket 98-141, pp. 4 and 13.

    19In the Applications of NYNEX and Bell Atlantic, FCC Memorandum Opinion and Order (Aug. 14, 1997), para. 169.

    20Chunrong Ai and David E.M. Sappington, "The Impact of State Incentive Regulation on the US Telecommunications Industry," Working Paper, Department of Economics, University of Florida. Available at http://bear.cba.ufl.edu/sappington/pprs.html.

    21Affidavit of James S. Kahan, CC Docket 98-141, paras. 57-58.

    22Bell Atlantic-GTE Public Interest Statement, p. 6.

    23"US Telecommuting Trend Surpasses 11 Million," at http://etrg.findsvp.com/prls/pr97/telecomm.html.

    24See http://www.jala.com.

    25For example, deregulated U.S. transportation and communications industries consistently experience inflation-adjusted price reductions of 25-50 percent within 10 years of deregulation. See Robert Crandall and Jerry Ellig, Economic Deregulation and Customer Choice (Mercatus Center, 1997).