Time Inc.'s entry into the entertainment industry

Question 1: How attractive is the merger of Time with Warner?

Due to the high value enhancement opportunities the merger of Time with Warner is economically very attractive:

(a) What are the value enhancement opportunities?

A merger only makes economic sense, when the merged firm is worth more than the two firms separately. Generally there are three main reasons that justify a merger. In the case of Time and Warner those three motives are present:

1. Horizontal merger leads to economies of scale

Horizontal mergers are defined as “combination of two firms in the same line of business” (Brealey, Myers & Allen, 2006, p. 871). Since Time and Warner are both in the same line of business, their merger can be considered as horizontal. The primary reason for horizontal mergers is the exploitation of economies of scale. “The savings come from consolidating operations and eliminating redundant costs, […] sharing central services such as office management and accounting, financial control, executive development, and top-level management” (Brealey, Myers & Allen, 2006, p. 874). Time and Warner are also following these goals, but more important than economies of scale resulting from a horizontal merger are the benefits of a vertical merger.

2. Vertical merger

“A vertical merger involves companies at different stages of production. The buyer expands back toward the source of raw materials or forward in the direction of the ultimate consumer” (Brealey, Myers & Allen, 2006, p. 874). The raw material in our case is the content, i.e. movies and series. By “direction of the ultimate consumer” different distribution channels are meant. “Vertical mergers seek economies in vertical integration. […] One way to achieve economies of scale is to spread fixed costs over a larger volume of production” (Brealey, Myers & Allen, 2006, p. 874). This is the main motivation of the merger as Munro and N.J. Nicholas wrote in their Letter to shareholders: “To […] achieve the necessary economies of scale, companies will have to grow dramatically. In the media and entertainment business of the future, the winner will own the copyrights to creative products, as well as avenues of distribution” (Harvard Business School [HBS], p. 5).

3. Complementary resources

Another reason for merging is when “the two firms have complementary resources - each has what the other needs - […]” (Brealey, Myers & Allen, 2006, p. 874). This is exactly the case for Time and Warner. Warner has a huge amount of content in their Warner Brothers subsidiary and Time has a strong distribution channel with HBO and a strong position in the cable television franchise. Together Time and Warner can benefit from their complementary resources. The production costs of movies are increasing rapidly and it seems less chancy when a company knows it can get its money back by using all the different distribution channels.

(b) Is the proposed exchange ratio of 0.465 per Warner share attractive?

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[Warner’s stock price after the merger announcement was used for calculations because the market already included the effects of the merger into the previous stock price. Time’s trading day low-price was used for calculations because the price increased afterwards due to tender-offer speculations.]

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Conclusion:

The exchange rate is very attractive for Warner’s shareholders, because they will get $515 million more than their original value of investment. For the same reason the exchange ratio is unattractive for Time’s old shareholders, because they have to suffer the loss of this $515 million. Moreover, the overall NPV of the merger is negative. As following table shows, after the merger Warner’s shareholders will be relatively better off than Time’s shareholders. This might be a reason why Warner’s managers have been ready to merge with Time and gave up their managerial jobs.

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Table 1: Shareholder wealth

Question 2: What prompted Paramount’s interest in Time?

The reasons for Paramount’s interest in Time are mostly of strategic nature. According to Paramount’s chairman and CEO Martin S. Davis, the arguments for a merger are basically the following:

- Further vertical integration
- Unparalleled range and depth
- Strong position for global growth

- Wide range of products
- Magazine and book publishing
- Motion picture and TV production and distribution
- Cable systems and cable programming

Time and Paramount would complement each other in various fields. The following two tables show the shares of revenues for different parts of the two companies.

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Table 2: Time’s share of revenues

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