Wednesday, 24 August 2011

Sims in the hot seat with the Foxtel / Austar merger following Metcash loss


Introduction
The ACCC’s recent Statement of Issues concerning the proposed merger between Foxtel and Austar was met with a great deal of consternation. The most strident criticism of the ACCC’s analysis came from Foxtel chief, Kim Williams, who labelled the ACCC decision as lacking any evidentiary basis and an example of “extravagant technology romanticism.”

In many respects, the criticism of the ACCC’s Statement of Issues was quite puzzling when one appreciates that it was entirely consistent with the ACCC’s published policy for the assessment of mergers, as set out in the Merger Guidelines. Accordingly, the ACCC’s views could not have come as a surprise to Foxtel, given that it must be familiar with the ACCC’s analytical approach to defining markets and analysing the competitive effect of mergers.

One is left wondering whether Foxtel’s strident criticisms of the ACCC Statement of Issues may have been motivated less by genuine puzzlement by the ACCC’s decision and more by a desire by Foxtel to pressure the new Chairman of the ACCC, Mr Rod Sims, into allowing the proposed merger to proceed.

There is no doubt that Sims will now be under even greater pressure to let the Foxtel – Austar merger through after the ACCC’s apparently comprehensive defeat in the Metcash case.

ACCC’s decision
The ACCC defined a number of separate markets in its Statement of Issues:
  • the national market for the supply of subscription television services to consumers; 
  • the national market for the acquisition of audio visual content; 
  • the national market for the supply of advertising opportunities to advertisers; and 
  • various telecommunications markets. 
The most controversial market defined by the ACCC was the national market for the supply of subscription television services to consumers. In relation to this market, the ACCC stated:

The ACCC’s preliminary view is that there is a national market for the supply of subscription television services to consumers. Other sources of supply of audio visual content to consumers, including FTA (Free to Air) television, mobile TV and internet content, are not sufficiently close substitutes to be considered in the same market.[1]

While the ACCC acknowledged that FTA operators compete to some extent with subscription television providers for the supply of audio visual content to consumers, in its view this has not developed to an extent where they could be considered to be close substitutes.

The ACCC’s statement appears to be a reference to actions by FTA providers to sell content to consumers through such relatively new technology as mobile TV, YouTube and Apple TC/iTunes.

Accordingly, the ACCC concluded that FTA would not act as a constraint on the pricing decisions of subscription television providers such as Foxtel and Austar.

In relation to the market for the acquisition of audio visual content, the ACCC largely accepted that there was close competition between FTA providers and subscription television providers. For example, FTA providers provided strong competition in relation to the acquisition of individual entertainment programs and sporting rights.

However, the ACCC noted that there were noticeable variations in the level of competition between FTA and subscription television providers depending on the types of audio visual content.

The ACCC also appears to have accepted that FTA television advertising is likely to be a sufficiently close substitute to subscription television advertising.

ACCC Concerns
The ACCC identified a number of issues of concern about the proposed Foxtel Austar merger.

The ACCC stated the preliminary view that the proposed acquisition was likely to substantially lessen competition in the national market for the supply of subscription television services. This conclusion was based on:
  • the narrow market definition which excluded FTA providers from the market and 
  • the belief that Foxtel and Austar would have the ability and incentive to compete directly following the rollout of the NBN.
In relation to the latter point, the ACCC stated:
As a result of programming arrangements entered into in the 1990s, agreements between FOXTEL, Austar and various content providers in effect currently divide the national subscription television market into two significant market segments; the metropolitan regions which are serviced by FOXTEL, and regional and rural Australia which is serviced by Austar. Further, the costs of expansion associated with distribution via traditional distribution platforms may have acted to maintain this geographic division. However, with the technological changes expected in the industry in the near future, it appears that FOXTEL or Austar (or both) will have the ability and incentive to expand beyond their current geographic footprints in the foreseeable future.
In other words, the ACCC believed that historical factors had lead to the market for the supply of subscription television services being segmented with Foxtel operating in the metropolitan areas and Austar operating in the regional areas.

The ACCC also believed that this historical and quite artificial lack of competition between Foxtel and Austar in geographic terms was likely to end with the roll out of the NBN. As stated by the ACCC:

To date, Foxtel and Austar have focused on growing their businesses in their existing geographic footprints as subscribers have continued to take up subscription television services. Over time, the incentives for FOXTEL and Austar to look to new opportunities for business growth, which may include geographic expansion of their existing operations, are likely to increase.

Expressed another way, the ACCC believed that both Foxtel and Austar had not sought to enter the other’s geographic territories in the past because they were more focused on winning customers within their existing geographic territories.

The ACCC concluded that there was unlikely to be any constraint on the merged firm from alternative subscription television providers and also that there was unlikely to be any new entry to the market for the provision of the subscription television services due to the high barriers to entry.

Foxtel response to ACCC decision

Following the ACCC’s Statement of Issues, various newspapers reported that Foxtel was contemplating legal action in the event that the ACCC blocked its proposed merger with Austar.

In particular, Mr Kim Williams, the CEO of Foxtel, was quite strident in his criticism of the ACCC decision. He is reported to have said that the ACCC decision was short on fact and full of bald assertions:
While the ACCC has raised some high-level issues, it provides limited evidence to back up some of its assertions. On this basis we believe Foxtel/Austar would be well positioned to have some success should it ultimately choose to take the ACCC to court, although we would still see a negotiated outcome as preferable for all parties and is therefore still more likely.[2]
Mr Williams was also quoted as saying:
What we have in the commission's statement of issue is a recital of opinions which do not have recourse to any kind of evidence. Parts of the commission are entitled to have their own personal opinions, but fortunately our legal system doesn't operate that way.

The commission seems to be suggesting in its paper – to test market views I must emphasise – that anything but Foxtel is a satisfactory conclusion. Frankly that is not good enough.
The ACCC seems to ignore the technological change that is enabling a host of well-capitalised new entrants to come into the TV market, for example, Apple, Google and Facebook.
What would appear to be evident in the commission’s paper is extravagant technology romanticism with an absence of evidentiary fact.[3]
In particular, Foxtel appeared most concerned about the ACCC’s conclusions that it did not consider subscription television and FTA television to be in the same market and that the proposed merger would eliminate potential competition between Foxtel and Austar. In this regard, Mr Williams said:
We believe that some of the ACCC arguments would be difficult to defend in court. For example, the view that pay TV and FTA don’t really compete and Foxtel and Austar would move into each other’s markets under the NBN.
Mr Williams’ claimed that the suggestion that Foxtel and Austar may become direct competitors in the future would be “an act of economic folly”.

Validity of Foxtel’s criticisms
Foxtel’s criticisms of the ACCC’s decision have little merit. The ACCC has not gone off on a tangent in its analysis but rather it has applied its published Merger Guidelines faithfully and correctly.

The ACCC’s approach to assessing mergers is clearly set out in its Merger Guidelines.

The first step in the analysis of a merger is to define the relevant market. This commences with a consideration of the level of overlap between the parties to the proposed merger:
The ACCC’s starting point for delineating relevant markets to assess a merger under s. 50 of the Act is identifying the products and geographic regions actually or potentially supplied by the merger parties. The ACCC then focuses on defining markets in areas of activity where competitive harm could occur. This must be assessed on a case-by-case basis. Generally, the ACCC focuses on overlaps between the products or geographic regions supplied by the merger parties, or some other meaningful economic relationship—such as an actual or potential vertical relationship or where the products supplied by the merger parties are complementary in nature. It is not uncommon for more than one market to be identified in any particular merger review.[4]
In other words, the first step in defining the market in the Foxtel and Austar merger would be to identify the overlap in the products and services which Foxtel and Austar sell or acquire in the market – namely subscription television services, audio visual content and advertising space.

The next stage is to consider whether the dimensions of this initial market should be expanded in product, geographic or functional terms to include close substitutes.

The ACCC then considers what other products and geographic regions, if any, constitute relevant close substitutes in defining the market. Importantly, the ACCC defines markets by reference to products and regions not by reference to the firms actually supplying those products or regions at the time of the merger.

The ACCC has to work out whether there are other products which are close substitutes to the goods or services being supplied by the merger parties. This may include goods or services which a customer may switch to if given sufficient price incentives.

In practical terms, the way this operates is to effectively dilute the market share of the merger parties in the market.

For example, if the market was limited to the services provided by the merger parties their market share would be 100% and they would be a monopoly. However, if a supplier in another state with the same total output as the merged firm was able to offer a competitively price substitute product, they would be included in the relevant market. This would have the effect of diluting the merged firm’s market share from 100% to 50% once the other firm’s sales had been included in the market.

This approach to market definition is based on the application of two tests – the Hypothetical Monopolist Test and the SSNIP test (also known as the price elevation test). The ACCC explains the application of these tests in its Merger Guidelines as follows:
The HMT determines the smallest area in product and geographic space within which a hypothetical current and future profit-maximising monopolist could effectively exercise market power. In general, the exercise of market power by the hypothetical monopolist is characterised by the imposition of a small but significant and non-transitory increase in price (SSNIP) above the price level that would prevail without the merger, assuming the terms of sale of all other products are held constant.
The process of applying the HMT starts with one of the products and geographic areas supplied by one or both of the merger parties. If a hypothetical monopolist supplier of this product cannot profitably institute a SSNIP because of customers switching to alternative products, the next closest demand substitute is added. If a hypothetical monopolist supplier of this extended group of products cannot profitably institute such a price increase because of customers switching to alternative products, the next best substitute is added. The collection of products is expanded until a hypothetical monopoly supplier of all those products could profitably institute a SSNIP.
A SSNIP in the context of the HMT usually consists of a price rise for the foreseeable future of at least 5 per cent above the price level that would prevail without the merger.
While the HMT is a useful tool for analysis, it is rarely strictly applied to factual circumstances in a merger review because of its onerous data requirement. Consequently, the ACCC will generally take a qualitative approach to market definition, using the HMT as an ‘intellectual aid to focus the exercise’.
This means that the ACCC will assume that the merged firm is in fact a monopolist (which makes sense given that it is only their sales which have been included in the market in the first step of the market definition process) and then apply the SSNIP test.

The SSNIP test involves the ACCC asking the question whether customers of the merger parties would switch to another product or source of supply in response to a small non-transitory increase in price by the hypothetical monopolist. This test is used to work out what products and sources of supply are close substitutes.

In the present case, the ACCC would have had to ask itself how existing customers of a hypothetical merged Foxtel and Austar company would react if the merged firm put up its prices by 5%. For example, would existing customers of Foxtel and Austar switch to another product or source of supply if the price of say the Family Package went up from $75 per month to $79.90 per month.

It is quite apparent that when one asks this specific question the conclusion has to be that subscription television services and FTA television services are in separate markets. It would not make any sense for an existing customer who is currently paying $75 per month for a Family Package to suddenly decide to cancel their subscription and switch to FTA in response to a $3.90 price rise. This consumer has already made a decision that the services they are receiving from Foxtel for $75 per month are worthwhile and superior to FTA television.

This is not to say FTA will not have some impact on the purchasing decisions of prospective consumers. There are likely to be many consumers who were previously considering whether to purchase a subscription television service, who will now decide against making that decision due to the relatively recent expansion of FTA channels.

However, do the decisions of these consumers not to buy a subscription television service because of the improved range of FTA channels constrain Foxtel or Austar’s pricing decisions in any meaningful way?

The answer is clearly no. Foxtel and Austar will retain considerable pricing discretion in relation to its existing customers because these customers are highly unlikely to switch to FTA television in response to a SSNIP.

The Hypothetical Monopolist Test and the SSNIP test are not novel or unique tests. Rather, these tests are applied by virtually every leading merger regulator in the world. These tests are also generally accepted analytical methods to defining the relevant market.

Foxtel’s other major criticism of the ACCC’s decision relates to the ACCC’s conclusion that Foxtel and Austar are likely move into each other’s markets under the NBN. Foxtel disputed the ACCC’s conclusion that Foxtel and Austar were likely become head-to-head competitors in the market once the NBN has been established.

The ACCC makes it very clear in its Merger Guidelines that it considers supply-side substitution in defining the relevant market. This means that the ACCC will look at the ability of other suppliers to, either, start manufacturing the same goods or services as the merged firm by diversifying, or commence the supply of the same goods or services as the merged firm from a more distant geographic location. The first type of supply-side substitution depends largely on whether the other firm’s manufacturing plant or distribution system can be adjusted quickly and relatively cheaply to provide the relevant product or service at a competitive price. The second type of supply side substitution depends primarily on freight differentials.

It is not clear whether Foxtel submitted to the ACCC that Foxtel and Austar are not in fact competitors because they operate in different geographic markets in the supply of subscription television services.

However, the fact that Foxtel and Austar compete head-to-head in the Gold Coast area undermines any claim that Foxtel may have made that they are in a different geographic market to Austar. The fact that Foxtel and Austar compete in Gold Coast proves that such head-to-head competition is clearly possible.

It seems, from the limited public information which is available that Foxtel must have accepted that Foxtel and Austar are in the same geographic market for the supply of subscription television services, but that there were economically rational reasons for the companies not to compete.

This argument must have been presented to the ACCC in terms of merger factor (f) which requires the ACCC to consider the availability of substitutes in the market – section 50(3)(f)

Section 50(3)(f) is probably the least well understood merger factor. Often it is presented to the ACCC in merger submissions as simply a rehash of market definition. However, this is not the correct approach to section 50(3)(f).

As stated above, the first step in the merger review process is to define the relevant market. Once this process has been completed, the ACCC will then prepare a market share table which shows all the competitors in the market and their respective market shares. For example:

National market for
the supply of Product X

Company A 40% market share

Company B 20% market share

Company C 20% market share

Company D 10% market share

Company E 10% market share


If Company A and Company B are proposing to merge, then it would be important for the ACCC to assess the likely competitive responses of each of the remaining competitors in the market. The ACCC would have to determine whether the remaining competitors would be willing and/or able to compete with the merger firm or whether they would become price followers?

For example, if Company C is a new start up company which has proven to be highly innovative and aggressive in the market, it may be able to constrain the pricing decisions of the merged firm.

On the other hand, if Company C and D both have no excess capacity in their manufacturing plants, they may be unable to respond to prices increases by the merged firm by increasing their output.

This qualitative consideration of the relative strengths and weaknesses of the competitors in the market who provide close substitutes has to occur somewhere in the ACCC’s analysis. The appropriate place for this analysis to take place is in the ACCC consideration of merger factor (f).

Therefore, in the Foxtel - Austar matter it would appear that Foxtel accepted that Foxtel and Austar were in the same market, but then argued that they would not exercise a competitive restraint on each other’s pricing decisions for other reasons under the section 50(3)(f) merger factor.

There were some media reports that indicated that the merger parties had put the following argument to the ACCC. Namely, that Foxtel and Austar would not constrain each others pricing decisions because it would cost each of them more money to pursue customers in the other’s geographic territory than it would to keep focusing their efforts on trying to gain new customers in their existing geographic territory

In other words, Foxtel submitted to the ACCC that it would not make any sense for Foxtel to try to win an existing customer from Austar in a regional area, because they would be able to make a bigger margin by gaining a new customer in a metropolitan area.

These submissions are tantamount to Foxtel saying because it can generate a margin of say 20% from a metropolitan customer and only 5% from winning an Austar customer, it would be “economic folly” for it not to focus exclusively on winning new metropolitan customers.

Unfortunately, this argument makes absolutely no economic sense, particularly in relation to subscription television services. In a competitive market, companies will generally try to win customers from anywhere and from anybody as long that one additional customer is profitable for the company.

While there may be some rare situations where companies may not seek to win low margin customers, this is usually where the costs of winning a new customer are very high. A good example of this situation is in relation to large construction contracts where the costs of preparing a tender can be very significant.

However, the marketing costs incurred in trying to win new subscription television customers do not appear to be significant. Indeed, it seems that the primary marketing technique used by Foxtel to win new customers is to undertake regular letterbox drops of written advertising materials, which is hardly a high cost marketing technique.

Accordingly, the ACCC would be right to reject Foxtel’s argument as to why Foxtel and Austar currently do not try to compete more vigorously against each other in more geographic areas than simply the Gold Coast.

Whilst there may be other reasons why Foxtel and Austar do not compete head-to-head in every market in Australia with the exception of the Gold Coast and apparently, have no interest in competing head-to-head in these markets in the future, these reasons do not appear to be based on any rational economic theory.

Decision time for Rod Sims

Given the extreme nature of Foxtel’s comments about the ACCC’s decision, one could be forgiven for believing that the ACCC had applied novel and untried economic theories to its consideration of the Foxtel – Austar merger. However, this belief would be mistaken.

The reality is that the ACCC has faithfully and transparently applied the methodological framework outlined in its Merger Guidelines to the Foxtel - Austar merger and reached a number of quite predictable and analytically correct conclusions. The methodological framework outlined in the Merger Guidelines (which incidentally were first issued by the ACCC in 1999, over 10 years ago) are based on widely accepted economic principles that are utilised by virtually every other leading overseas merger regulator.

Therefore, questions arise as to:
  • why was Foxtel apparently so surprised by the ACCC’s preliminary views? 
  • why was such a large and sophisticated company such as Foxtel so puzzled by the ACCC’s findings about the merger given that these findings were quite predictable for anyone with even a cursory understanding of the ACCC’s approach to merger analysis and its published Merger Guidelines? 
  • why was Foxtel so surprised that FTA television services were not included in the market for subscription television services given that it must have know the way that the SSNIP test is applied by the ACCC to determine the existence of close substitutes?
It is highly unlikely that Foxtel has been poorly advised in relation to the ACCC issues which were likely to arise in relation to the Foxtel – Austar proposed merger. Accordingly, there must be another explanation for Foxtel’s extreme position.

Is it the case that Foxtel’s comments may have been driven by strategic considerations?

It is well known that the Statement of Issues issued by the ACCC on 22 July 2011 was one of the last major decisions made by Graeme Samuel during his reign as ACCC Chairman. In fact, some commentators were very surprised that Mr Samuel went ahead and made such a significant decision so close to the end of his appointment given he would not be around to finalise the decision.

Indeed, many commentators expected Samuel to postpone the Statement of Issues in relation to the Foxtel - Austar merger so that it could be considered by the new ACCC Chairman, Mr Rod Sims, once he had taken up his new role.

However, now the responsibility of making a final decision on the Foxtel – Austar merger rests squarely on Rod Sims. Indeed, this is likely to be his first major merger decision during his term as the Chairman of the ACCC.

Accordingly, there may be some grounds for suspecting that Foxtel’s strident criticisms of the ACCC’s decision may have been made for the strategic purpose of trying to put maximum pressure on Rod Sims to let the deal through.

Foxtel may have come to the conclusion that Rod Sims will not want to start his role at the ACCC by embarking on major litigation against the combined might of Foxtel and Austar and their main financial backers, who include News Limited, Telstra and Consolidated Media Holdings.

Unfortunately, it now seems that Rod Sims is in the position of either standing by the ACCC’s previous Statement of Issues and opposing the Foxtel – Austar merger or abandoning the Statement of Issues and letting the merger through.

If Rod Sims opposes the Foxtel – Austar merger it is likely that litigation will ensue. This litigation is likely to be both very expensive and time consuming for the ACCC. Indeed, it would have the potential to bankrupt the ACCC, particularly when one factors in the enormous legal bill that the ACCC will be receiving from Metcash and Franklins unless it can overturn Justice Emmett’s decision to dismiss the ACCC’s case seeking to prevent that merger.

On the other hand, if Rod Sims lets the merger through it may appear that he has caved in to pressure from Foxtel. Such a perception would not auger well for his future role as the Chairman of the ACCC.

Unfortunately, for Rod Sims there does not appear to be a simple third option such as accepting the divestment of strategic assets in order to mitigate the potential anti-competitive effects of the proposed merger.

The only possible alternative for the ACCC may be to let the deal through with some form of behavioural undertaking from the merged firm. For example, a behavioural undertaking from the merged firm that they agree to make particular content available to fledgling providers of content on reasonable terms for a defined period of time may be the solution.

However, one thing is clear. It would have made Mr Sims’ initiation to the role of ACCC Chairman a great deal easier if the former ACCC Chairman of the ACCC had simply deferred the preliminary decision on the Foxtel Austar merger until after Rod Sims had taken over.

Sims’ decision has now been made a great deal harder in the light of the ACCC’s apparently comprehensive loss in the Metcash case which will no doubt raise significant questions over the ACCC’s methodology and approach to merger analysis .



[1] Statement of Issues – Foxtel – proposed acquisition of Austar United Communications Limited, dated 22 July 2011 - http://www.accc.gov.au/content/index.phtml/itemId/975742
[2] “Foxtel eyes legal action against ACCC if Austar acquisition is determined anticompetitive”, The Australian, 25 July 2011.
[3] “ACCC delivers hammer blow to Foxtel’s bid”, The Australian, 23 July 2011.
[4] ACCC Merger Guidelines, 2008 - http://www.accc.gov.au/content/index.phtml/itemId/809866

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