Managerial Economics and Business Strategy, 7e Page 1

Time Warner Solution to MEMO 5:

Strategic Analysis

While the outlook for the five individual units that comprise Time Warner appears bleak,

the underlying theme of complementarities helps paint a much brighter picture. In what

follows, we examine each of the business units of Time Warner through the lens of the

five forces model. Then, we will tie then analysis together to examine how

complementarities could make the overall prospect for the company very bright. Overall,

this solution is to provide a guide to some issues that students will likely raise; not be a

definitive answer.

Filmed Entertainment

Time Warner’s filmed entertainment unit is one of the most promising units for sustained

profitability. In 2003, domestic box office revenues from all motion pictures reach $9.45

billion. Additional revenues were generated on DVD and VCR sales, television licensing

and other related media products. The bulk of these revenue sources are generated by

seven companies that consistently dominant the production and distribution of major

films.

While many independent movie distributors exist within this market, true competitive

threats from another large-scale film producer and distributor is unlikely. The entry and

sunk cost nature of producing blockbuster hits prohibits new entry by a large-scale

producer and distributor. In addition, existing film producers’ reputations make entry by

new firms difficult.

Buyers of filmed entertainment products have very limited power. In a typical city, there

are many different movie theaters and consumers who want to view any given film. Film

producers are essentially monopoly producers of any particular film and price

accordingly. The number of substitutes for new release is relatively small. This is

relegated by those films simultaneously released or competition from at-home solutions,

such as movies on DVD and VCR format. Viewed in this way, newly released movies

may actually compete with similar movies previously released by the same producer.

However, there may also be a complementary component to certain new releases. For

instance, a new release such as Harry Potter and the Order of the Phoenix may motivate a

moviegoer to view previously released Harry Potter films. Buyers’ power in this market,

however, is limited.

As mentioned, the film industry is a relatively concentrated industry with only seven

major film producers and distributors. Instead of competing on price – which drives

profits down – rivals in the film industry compete on product quality. The product

differentiation competition helps sustain profits for firms operating in the film industry.

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The one area that threatens the film industry is the power of input suppliers. As the case

study mentions, escalating costs are the one weak spot in the film industry. To

continually improve film quality requires more intense visuals and paying top dollar to

attract the “right” actors and actresses. There are few substitutes for these individuals’

talent, which gives them some power over the producers and weakens the ability of firms

in the filmed entertainment industry to sustain profits.

Programming Networks

Time Warner’s cable programming network division generated $8.4 billion in revenues

during 2003. Basic cable programming networks rely on subscription fees charged to

cable and satellite carriers and advertisings fees.

Sustainability of profits in the programming network market is very good, despite

relatively low entry costs and competition. While dozens of new firms enter the

programming network market and a few exit the market, the growth in the number of

programming networks has been high over the past 10+ years. In 1994 there were only

106 programming networks compared to 340 in 2003.

While one might expect industry rivalry to be intense given the number of competing

programming networks, there are several things that ease industry rivalry in this market.

First is the product quality varies from programming network to network. This degree of

differentiation relaxes the type of competition that puts downward pressure on prices and

profits. In addition to product differentiation, Time Warner’s programming network is

vertically integrated with its cable systems division. This vertical relationship permits

monopoly cable systems providers with the ability to allocate limited channel space to its

other divisions instead of competing programming networks. This limits the power of

buyers since the programming division can charge an optimal transfer price.

Cable Systems

Time Warner’s cable system operations provide a variety of services to consumers such

as; analog and digital cable, broadband Internet access and telephone services.

Traditional markets for analog cable systems were awarded local monopolies further

enhancing the sustainable profitability of this market. While sustainable profits in

traditional cable systems operation have been good, the digital convergence of telephony,

Internet access and cable is threatening to upset the sustainability to profits.

While entry into the digital cable systems market requires large-scale infrastructure

investments and takes a long time to build, the 1996 Telecommunication Act has

deregulated the prices and encouraged entry into markets once controlled by local

monopolies. This has the effect of reducing the ability of this division to sustain profits.

In addition to offering analog and digital cable television, the cable lines are being

utilized for Internet and telephone services, which has attracted new entrants to the

market as well.

Managerial Economics and Business Strategy, 7e Page 3

Many buyers exist in the market for cable television, Internet and telephone services.

Until recently, there have been few substitute products and often required a relationship-

specific investment – the cable box or modem. These investments tend to raise

consumers’ cost of switching provides, but the level of the investment is typically less

than $100. Therefore, buyers’ power is tending to increase as substitutes become

available. This tends to decrease firms’ abilities to sustain profits.

Publishing

Three basic units comprise the publishing subsidiary of Time Warner: magazine

publishing; magazines online; and book publishing. This subsidiary of Time Warner

generated $5.5 billion in 2003. The sustainability of profits in this industry has been

called into question due to recent events.

Entry into the magazine publishing is relatively easy. There are no large entry costs nor is

it costly for producers of one magazine to switch to publishing another. Four of Time

Warner’s magazine 135 magazine titles account for 80 percent of its advertising

revenues, suggesting that Time Warner’s reputation in these markets is very strong.

However, despite strong reputation with certain titles, entry into this industry is easy with

900 new titles listed in the United States in 2003. Ease of entry into this industry weakens

firms’ ability sustain profitability.

The number of substitute products for individual magazines is high. It is, therefore,

important to price such that consumers perceive value to make one title competitive with

other competing titles. In addition, increased competition from competing distribution

mechanisms – online magazine subscriptions – threatens the profitability from traditional

magazine subscriber models.

Industry rivalry in the publishing industry is very high. Class action lawsuits alleging

deceptive and illegal marketing practices related to the way in which magazines attract

new subscribers, increases the competitive nature of the industry. Given the large number

of competitors in the publishing industry, concentration is relatively low.

The power of input suppliers is relatively low. There is a large number of print shops that

will print magazines and none of these print shops require a relationship-specific

investment. This will tend to lower the cost of publishing, which helps sustain industry

profits.

Buyer concentration is high and publishing magazines do not require any specialized

investments on the part of consumers. This suggests that consumers’ switching costs are

low. Taken together, these things suggest that buyers have significant power of the

sustainability of industry profits.

America Online

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America Online (AOL) was one of the earliest Internet service providers in the United

States. Its membership base grew to over 20 million subscribers in part due to AOL’s

proprietary content. AOL subscribers connect to the Internet via traditional dial-up

service. However, a competitive pressure from cheaper and faster broadband services is

threatening the sustainability of AOL’s profitability. Traditional cable and television

companies are competing directly with AOL’s services and its proprietary content

(product differentiation) is not enough to keep its membership base from switching to

broadband.

The competitive pressures from entry into the Internet service provider market as well as

the new products and services in this market severely diminishing the ability of AOL to

sustain profitability in this industry.

Time Warner: The Big Picture

While AOL is appears to be the weak link in the company, there are unexploited

synergies that could be realized throughout the Time Warner entity. What follows is a

brief outline of some of the synergies and complementarities that could be exploited to

enhance overall profitability for Time Warner.

There are two basic ways in which the AOL subscribership base could be utilized to

further enhance the value of Time Warner. First, align Time Warner’s broadband services

with AOL content and dial-up service. In this way, Time Warner’s broadband consumers

could benefit from AOL’s content and have Internet access (albeit, slower) while away

from home.

In addition, by setting optimal transfer prices, AOL could utilize the content provided by

Time Warner’s publishing division to further differentiate itself from its competitors.

This model would give Time Warner a first-mover advantage in this market and ease

some of the competitive pressures and lower costs of producing content. By exploiting

these complementarities, Time Warner would be able to lower costs and ease competitive

pressures that threaten the sustainability of profits in different industries.