AT&T’s Warner Media debacle broke the two most fundamental principles of M&A strategy

AT&T’s surprise announcement that it’s spinning off Warner Media closes the book on one of the greatest corporate strategy blunders of recent decades. While the deal’s timing was unexpected, the event itself was not. On the contrary, this deal or something like it was foreseeable, and was foreseen by some, years in advance.

The story of what happened is a tale of fundamental errors on an epic scale. The debacle will become a classic case to be studied intently by consultants, academics, and business people. It matters because it cost a great American company tens of billions of dollars at a time of intense competition in its industry. The effects will dog AT&T, its employees, and its shareholders for years.

In the proposed deal, Warner Media, known as Time Warner when AT&T bought it in 2018, will be spun off and combined with Discovery, assuming regulatory approval. AT&T paid $85 billion for Time Warner, not including assumed debt. It will get back about $43 billion, and AT&T shareholders will own about 71% of the combined Discovery-and-Warner-Media company, the name of which has not yet been disclosed.

The news is stunning because it unwinds what was arguably the largest transformation underway at any Fortune 500 company. Former CEO Randall Stephenson foresaw that cell phones would become primarily video viewing devices, in which case “controlling your destiny to some degree would be really important,” he told Fortune in 2019. The only way to do that, he believed, was “to own a big portfolio of premium content.” He began by buying satellite-TV distributor DirecTV in 2015, in large part for the programming rights it owned, then bought Time Warner—owner of HBO, the Warner Bros. studio, and several cable channels including CNN, TBS, and TNT– in 2018. Total cost, including assumed debt: a staggering $170 billion.

Stephenson’s control-your-destiny strategy made AT&T the most indebted non-financial company in America. Several Wall Street firms liked its chances. Morgan Stanley, JP Morgan, UBS, and others had “buy” or “overweight” ratings on the stock. Among those who foresaw trouble was longtime telecom analyst Craig Moffett. He downgraded AT&T to “sell” the day after a federal judge in 2018 cleared the Time Warner deal to go ahead. He based his reasoning on simple math. AT&T’s total debt, which he pegged at “an astounding $249 billion,” would hamper all the company’s operations, including basic cell phone service. His advice to AT&T: “Be careful what you wish for.”

Moffett was right. Even more prescient was strategy consultant Roger L. Martin, who made three specific predictions to Fortune in 2019: “The Time Warner acquisition will be a disaster. The CEO will lose his job. AT&T will get back half what it paid for Time Warner.” He was right on all counts. The TimeWarner deal was indeed a bust, as the spinoff announcement has made clear; CEO Stephenson retired last July 1, though just six months earlier the company had announced he would remain “through at least 2020;” and in round numbers AT&T is indeed getting back half of what it paid ($43 billion vs. $85 billion).

Martin is a former outside consultant to Verizon (2014 – 2018), so he certainly has skin in the game. Verizon made two bad investments in that period, buying Yahoo and AOL, both of which it recently sold at a loss, though the total dollars invested were less than 10% of what AT&T spent on its massive media strategy. In any case, Martin nailed AT&T’s future so precisely that you have to wonder how he made such confident predictions.

Turns out he relied on two foundational but frequently overlooked principles of M&A strategy.

The concept of “owner economics” is wrong

It’s a concept CEOs often invoke when justifying huge, expensive deals, and AT&T used it to support its Time Warner acquisition. When The Information asked an AT&T executive how the company would charge consumers low prices while programming costs were rising, he replied, “This is why you get into Warner Media. You get owners’ economics on the package so you can do math that you wouldn’t otherwise do.” Translation: If you own an asset rather than, say, renting it, you don’t necessarily need to make money on it. But that isn’ttrue. Investing capital at a return lower than its cost is a losing proposition for which investors and lenders will punish you.

If the deal doesn’t give you clear competitive advantage, you’re in trouble

Sounds so obvious, but it’s surprising how often CEOs lose sight of this simple rule. “If you can buy into a part of the industry upstream or downstream and you can have competitive advantage there, it’s kind of a no-brainer,” Martin says. But without that advantage, the deal is a loser. “If you’re AT&T, where do you stand? You’re spending less on content than Netflix and Disney, and you won’t beat Verizon on 5G. Where does that leave you?” It left AT&T losing in both the businesses that it was combining into a grand strategy.

Fixing that second error is the point of AT&T’s U-turn. In addition to dumping Warner Media, the company is reducing its dividend. Those steps free up billions of dollars that can be invested in a business AT&T knows something about: cell phone service. CEO John Stankey mentioned that returns on investments in 5G are highly attractive, in the mid-to-high teens. Investors liked the sound of that; the stock rose smartly on the announcement that AT&T was abandoning Hollywood.

It’s tempting to conclude that AT&T is getting back on track after an enormously expensive detour, but even that isn’t certain. While the company has been distracted, its competitors have not been. T-Mobile has become a significant force in the telecom industry, which it wasn’t in 2018, and Verizon has been focused on 5G expansion.

So here’s one more prediction from Martin—that over time, the cost of AT&T’s media distraction “could be as damaging to the company as the $42-billion write-off they’re going to have to eat.” Even after the spinoff, ending the misbegotten media debacle may not be as easy as AT&T hopes.

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