The Foxtel/Australis Merger

CHAPTER SIX

In this chapter I examine in detail the ACCC's 1997 decision to block the proposed merger between FOXTEL and Australis.  The discussion examines each argument in detail using market information and data at the end of 1997.

As stated above, the ACCC blocked the first merger between FOXTEL and Australis in February 1996 on grounds that there were barriers to entry in parts of the pay TV sector:

The fact that Optus Vision could not deliver via satellite until July 1997 meant that a merged Australis/FOXTEL would have a considerable head-start and "first mover" advantage, such that it would substantially lessen competition in the pay TV market (among other markets).  (Fels, 1996, page 8)

This government-created barrier to entry was lifted on 1 July 1997.  With the removal of this barrier Australis and FOXTEL anticipated no objection from the ACCC to their renewed attempt to merge in late 1997.  However, the ACCC again opposed the proposed Australis/ FOXTEL merger in October 1997, on two grounds.  First, it would substantially lessen competition in pay TV, even though there was now free entry into satellite delivery.  Second, and more controversially, it would also substantially lessen competition in local telephony if Optus's pay TV activities declined.  Indeed, the telecommunications issue quickly became central in the debate and prospective arguments of the ACCC.  Many regarded telecommunications as the real reason why the merger was blocked, even though Australis was not in the telecommunications business and, ironically, used C&W Optus's satellite to distribute its programming.

Telecommunications took on importance for two reasons.  The first was that Australia's two main telecommunications operators were shareholders in the two cable pay TV services -- Telstra owned 50 per cent of FOXTEL and Optus owned 100 per cent of Optus Vision at the end of 1997.  Second, the ACCC attached, and continues to attach, considerable importance to promoting facilities-based competition in telecommunications markets.  It took the position that the merger would put at risk facilities-based competition in the telecommunications sector by weakening Optus's ability to continue investing in its broadband network, which would provide direct competition to Telstra's former monopoly of the telephone wire into each Australian's home.

THE LEGAL FRAMEWORK

Mergers are regulated in Australia under the Trade Practices Act 1974 (as amended).  The object of the Act is "to enhance the welfare of Australians through the promotion of competition and fair trading and provision for consumer protection" (s 2).  Section 50 of the Act prohibits acquisitions that would have the effect of substantially lessening competition in any substantial market for goods or services in Australia.

In addressing this provision, it is now standard trade-practice analysis to proceed in a series of steps.  This begins by defining a "relevant" product and geographic market in the terms discussed in Chapter 5, and then calculating each firm's shares in the market as an initial indicator of market power.  When this factual inquiry has been completed, a detailed analysis of the merger is required to determine whether the merged entity has improved its ability to raise prices unilaterally (that is, free from effective competitive constraints) or otherwise to profitably influence the prevailing terms of trade.  A merger inquiry requires the ACCC to focus on a specific question:  in this case, would the merger of FOXTEL and Australis have enhanced market power to an extent that a substantial lessening of competition would be likely?

There is a presumption that a merger in a market with a small number of firms is more likely to lead to the merged firm being able to impose a profitable price rise, or decrease output/quality, than one where there are a large number of firms.  It will, however, not have this effect if (a) the merging firms do not effectively compete with one another or, if they do, (b) competition in the market in which they operate remains effective after the merger.

There are two reasons to doubt that the proposed merger would have reduced competitive pressures in pay TV depending on whether FOXTEL was present or not in Australis's broadcast areas:

1. where only Australis was present, then pay TV services were already priced at their profit-maximising level.  Hence, post-merger, these prices would not have increased;  and
2. where Australis faced competition from Optus and FOXTEL, continued competition between the two pay TV services was likely to hold prices at their current levels.

If these conclusions are accepted, then it is unlikely that any difficulties created for Optus as a result of the proposed merger would have been the result of anti-competitive abuse.  Indeed, even if this was not the case, the alleged link between pay TV and the success or otherwise of Optus's local telephony is weak, as will be shown below.

THE IMPACT OF THE MERGER ON THE PAY TV SECTOR

To examine the ACCC's principal arguments, it will be assumed, purely for the purposes of illustration, that pay TV is the relevant product market.  Obviously, if under this assumption the ACCC's case is weak, then it will be considerably weaker in a broader market which includes FTA television and potentially other forms of video entertainment.

From Three to Two

The proposed merger would have reduced the number of pay TV operators from three to two in some areas.  The ACCC appeared to regard this as sufficient to establish that the proposed 1997 merger would have substantially lessened competition.  The ACCC contended that the merger would result in an entity with about 73 per cent of all subscribers, nearly three times that of Optus, and would have enabled FOXTEL to launch a national satellite service.  Table 6.1 shows subscriber shares before and after the proposed merger using September 1997 figures.

Table 6.1:  Subscriber Shares of Pay TV Operators, September 1997

		Subscriber shares
Operator	Subscribers	Pre-merger	Post-merger
Optus Vision	180,000	25%	25%
FOXTEL	250,000	34%	}       49%
Australis	110,000	15%
Austar	176,000	24%	24%
ECTV	12,000	2%	2%
Total	728,000

Source:  Acocia Press Pty Limited

The ACCC's calculations exaggerated the impact of the merger.  A merged FOXTEL–Australis would not have had 73 per cent "market" share since this included Australis franchisees who were free to carry Optus programming if they could have negotiated a mutually satisfactory arrangement. ⁽³⁹⁾ In fact, ECTV and Austar did agree in 1998 to carry Optus programming.  Excluding the Australis franchisees, the merged entity would have had 360 000 subscribers -- or 49 per cent of all subscribers.

It is also necessary to distinguish clearly the geographic market in which the different pay TV operators carried on business.  The Australis franchisees did not compete in the same geographic market as Optus Vision or FOXTEL.

Australis Was Not an Effective Competitor

In assessing a proposed merger, the ACCC is required under Section 50(3)(h) of the TPA to consider "the likelihood that the acquisition would result in the removal from the market of a vigorous and effective competitor".  Clearly this was not the case given the financial state of Australis and the fact that it was losing subscribers and subscriber share.

Australis was an ineffective competitor, for a number of reasons.  First, it offered viewers less value for money, higher installation charges, and fewer channels than either Optus or FOXTEL.  In the face of the poor take-up of its pay TV offering, Australis withdrew from head-on competition with FOXTEL and Optus Vision in cabled areas.  Its total number of subscribers was declining, and it was progressively becoming insolvent and was forced to sell assets to stay afloat.

The second reason has to do with a previous decision of the ACCC affecting FOXTEL and Australis.  The programme arrangements between FOXTEL and Australis, which were approved by the ACCC, made the competitive impact of the merger de minimis.  It meant that FOXTEL already carried Australis's core movies and sports programming, and so the impact of the merger in altering the strength of competition to Optus through enhanced programming was minor.  Also, and critically, as the ACCC itself concluded when it approved the TNC Heads Agreement, without access to core movies and sports programming, FOXTEL would not have been commercially viable.  The Chairman of the ACCC had stated "to be a commercially viable pay TV service, FOXTEL wanted the movies of the Hollywood studios (Columbia, Universal and Paramount) that Australis had exclusively tied-up" (Fels, 1996, page 6).  The proposed merger would then not have altered FOXTEL's position in terms of programming.  The effect of the merger would have been to increase the number of channels on FOXTEL by only two.

Thus the ACCC was left with a situation of which it was the principal party supporting two-firm rather than three-firm competition.  Either there was competition between Australis and Optus without the TNC Heads Agreement because FOXTEL would not have entered, or, with the agreement, there was competition between only FOXTEL and Optus, because the consequence was that Australis was not able to compete effectively with cable-delivered pay TV and was commercially unviable.  Either way, the market could sustain only two operators. ⁽⁴⁰⁾  If three-firm competition was not viable, then the merger of a failing operator with one of the surviving operators would not have been likely to substantially lessen competition.  That is, one could not sustain the argument key to the ACCC's submission that "but for" the merger there would be three, not two, pay TV operators.

Merger Would Not Reduce Competition in Cabled or Non-cabled Areas

The conclusion that the proposed 1997 merger did not substantially lessen competition is supported by a more detailed appraisal of its impact by reference to individual geographic markets.  Depending on where they lived, Australians in late 1997 had a choice between one of three pay TV packages delivered in one of three ways:

1. Australis and its franchisees delivered programming by satellite or MDS;
2. FOXTEL distributed by Telstra's broadband cable which included core Australis programming;  and
3. Optus Vision distributed by Optus's broadband cable also offering telephony.

To assess the impact of the proposed merger, the incremental impact on market power needs to be examined separately in those areas where Telstra's broadband network had been built, and those areas where it had not been and where the FOXTEL TV package was not available.

Impact of the Proposed Merger Where FOXTEL's Pay TV Package Was Not Offered

In those areas where FOXTEL was not available, the proposed merger would not have lessened competition since it did not reduce the number of pay TV operators.  Optus would have faced the same level of competition post-merger as pre-merger.  Nor would the proposed merger have adversely affected the prospects of Optus in the DTH satellite business.  Optus owned the satellite and had reserved transponder capacity for its own use.  The proposed merger would not have affected the type of programming offered by Australis or its franchisees.  Under the terms of the TNC Heads Agreement, FOXTEL assigned to Australis the exclusive MDS and DTH distribution rights for all FOXTEL programming, to which FOXTEL had obtained MDS and DTH rights.  For these reasons, the proposed merger could not have lessened competition in those areas where Australis and FOXTEL did not overlap.

Impact of the Proposed Merger in Areas Where FOXTEL Was Offered

In those areas where Telstra's broadband network had been built, the FOXTEL programming package was in direct competition with the programming packages offered by one or both of:

• Programming via DTH or MDS, marketed by Australis and to a lesser extent one of its franchisees;  and
• Optus Vision on broadband cable.

While the proposed merger would have reduced the number of competing programme packages, this is unlikely to have had a material impact on competition.  It was generally recognised that Australis was unable to compete against cable operators with a bigger package, whether FOXTEL or Optus Vision.  Australis lost subscribers in cabled areas.  As a result, Australis refocused its marketing in non-cabled areas.

Competition in the Programme Rights Market

It was also suggested by the ACCC that the merger would eliminate one bidder for programming, thus reducing competitive pressures in the programme rights market.  It is not, however, clear what follows from this theoretical observation, given that most informed commentators agree that the prices paid for Hollywood movies as a result of earlier competitive pressures were excessive, and placed a crippling financial burden on the industry.  As the demise of Australis showed, when the programme contracts come up for renegotiation, programme rights fees decline significantly to more "realistic" levels.  Optus has also signalled a renegotiation of its studio agreements.

The disappearance of one bidder from a more stable pay TV market does not imply that that market will be less competitive.  The driving force for the ferocity of bidding was the entrants' strategy to knock out other competitors by securing exclusive rights to the "killer applications".  When the parties realised that this strategy had created an unsustainable cost structure, a more realistic competitive relationship began to develop between the parties.  Without this consideration, the demand for programming, or rather its terms, would not have altered significantly because of the merger.  This is because FOXTEL already took Australis's programming.  If Australis was viable, then by virtue of its 25-year deal with FOXTEL it would enter the programme rights market bidding, on the basis of the revenue potential of its own subscribers, those of Australis's franchisees and FOXTEL.  Post-merger, the new entity would have been bidding on exactly the same basis.  Since Australis proved not to be a viable competitor, the merger on a forward-looking basis would not have substantially lessened competition.

The ACCC argued that FOXTEL/Australis would, because of the increase in its installed subscriber base, be able to bid programming away from Optus Vision.  This would result in the virtuous circle discussed in Chapter 4, with the result that Optus Vision would have been thrown into a vicious cycle of low subscriber numbers, reduced finances and poor programming.  When Optus was sufficiently weak, FOXTEL/Australis would move to raise pay TV charges.

The ACCC's assessment of the impact of size was exaggerated, for a number of other reasons.  First, the addition of 110 000 Australis subscribers using satellite and MDS (the latter regarded as an obsolete delivery method) was not likely to cause a dynamic implosion of Optus Vision of the type put forward.  As noted in Chapter 4, network effects are not strong in pay TV.  Second, different programme packages may imply that consumer demand is willing to support more than one package.  Third, the willingness and ability of pay TV operators to acquire programming do not depend on the number or their share of existing subscribers but expected future subscribers and expected future profitability ("expected" in the forecasting or probabilistic sense).  All pay TV operators have their eye on increasing penetration rates from their present levels (about 15 per cent of all Australian homes) to somewhere between the "worst case" projection of 30 per cent and the "best case" of 70 per cent (the penetration rate in the US).  That is, they are playing for anything up to three to six times the number of subscribers currently watching pay TV.  It is therefore not realistic or credible to claim that a pay TV operator with, say, 5 per cent take-up who could boost potential subscriptions by as much as twelvefold would not bid a sum much higher than the current number of subscribers justifies.  The willingness to pay for exclusive programming by pay TV operators is based on future, not present, subscriber numbers.  That is why pay TV operators pay large amounts for the exclusive TV rights to live sports.  This in turn means that they would be willing to invest in programming and infrastructure expansion well beyond that justified by current profitability in order to build the business and attract subscribers to the service.  In all developing pay TV industries, it is investment in programming which has priority, not profits from a small but growing base of subscribers.

In short, this analysis was simply not credible given the modest gain in subscribers involved and Optus Vision's strong line-up of exclusive programming.  The ACCC needed to go beyond establishing that Optus would have been harmed in arguing that FOXTEL would have gained increased market power sufficient to substantially lessen competition.  These are not the same, since firms in competitive markets overtly seek to harm their competitors by offering better and cheaper products.

The Merger Will Not "Give Less and Charge More"

Pay TV prices can be increased by firms with market power only if, to quote the Australian courts, they "give less and charge more". ⁽⁴¹⁾  Evidence of an abuse or exercise of market power requires that any profitable price be shown to be accompanied by output-reducing actions by the merged entity. ⁽⁴²⁾  The ACCC must show how the merged FOXTEL/Australis would have reduced the number of channels or the quality of its programming.  Given that the ACCC argued the opposite -- that as a direct result of the merger, FOXTEL/Australis would outbid Optus Vision and give FOXTEL/Australis's viewers better programming -- any price increase would have been accompanied by an increase in "output" in terms of better and/or more channels.  That is, the merger would harm a competitor by giving a better deal to the FOXTEL/Australis viewer!  Even if the ACCC did establish that the merger would have raised pay TV prices, this need not have been in itself evidence of enhanced market power, but merely evidence that the merged entity was offering its subscribers more for their money.  Thus, the ACCC's position appeared to boil down to the vague claim that the merged entity would have been able to corner the market in exclusive programme rights, undisturbed by the prospect of future competition law investigation.

TELECOMMUNICATIONS COMPETITION

The second plank of the ACCC's claim was that the merger would substantially lessen competition in the market for the supply of facilities-based local telephony services and broadband services.

Pay TV Pull-through

The ACCC case rested on the claim that there was a "close link" between the take-up of pay TV and the take-up of local telephony services:  specifically, that pay TV subscribers attracted or "pulled through" telephone customers, so that a reduction or low growth of pay TV for Optus would detrimentally affect its prospects and ability to compete with Telstra in the provision of local telephony.  In support of this claim, the ACCC relied on evidence from the UK which purported to show that 50 per cent of cable pay TV subscribers take local telephony from the same supplier, and that these subscribers are less likely to "churn".  In short, the ACCC (1997) claimed that as a result of the proposed merger, Optus would not be able to provide an effective competing pay TV service, and hence was unlikely to be an effective competitor in providing a local telephony service.

However, the various descriptions of the UK cable sector offered by or on behalf of the ACCC were inaccurate.  The evidence shows that, to the contrary, telephony pulls through pay TV.

The UK pay TV sector differs considerably from that in Australia.  It consists of DTH satellite pay TV, supplied by BSkyB, and regional cable operators.  BSkyB has most subscribers (although cable is catching up), and supplies most of the premium channels to cable networks.  For over a decade the UK's cable pay TV sector has been in a parlous state, with penetration languishing at 22 per cent of homes passed.  This has led to consolidation of the industry and pushed share prices for those operators listed on the London Stock Exchange well below their issue price.  In short, as a pay TV business, UK cable has failed.  At the time the ACCC was blocking the merger in Australia, CWC and other cable operators in the UK were publicly discussing pulling out of pay TV or handing over the sales and marketing to BSkyB, Mirror Newspaper Group and/or Flextech.  Such discussions do not support the ACCC's belief that pay TV is critical because it "pulls through" telephony.

It is, therefore, an extraordinary and counterfactual claim to infer from the evidence that the weak performance of pay TV explains the strong performance of the emerging telephony business of UK cable operators.

A careful examination of the UK data establishes the reverse of that claimed by the ACCC.  In the UK, telephony now drives cable take-up, and pay TV is regarded as an add-on.  Telephony provided by cable operators has higher take-up than pay TV and is estimated to generate two-thirds of cable operator revenues (in the case of Cable & Wireless Communications the figure is 90 per cent).  UK cable operators are transforming themselves into telephone companies with the add-on of pay TV.

Figure 6.1 traces the growth of cable TV and telephony in the UK from 1986 to April 1998.  The period is divided into two:  before the duopoly review in October 1991 and after, when cable operators were allowed for the first time to offer cable telephony to their subscribers in their own right.  There are two trends:  the rate of growth of pay TV penetration was greater before the duopoly review than after, and pay TV penetration rates stagnated at the same time as the penetration of telephony increased.  The outcome is that telephony penetration exceeds that of pay TV. ⁽⁴³⁾  Figure 6.2 uses aggregate data to reinforce this point.  It is direct evidence that UK cable operators are moving away from pay TV to telephony, and the increasingly subsidiary role being played by pay TV in "pulling" the UK broadband cable sector.

Figure 6.1:  Growth of Cable TV and Telephony Penetration in the UK

Source:  ITC

Figure 6.2:  Telephony and Cable TV Subscribers (UK)

Source:  New Media Markets

The changes in the investment in cable rollout support this interpretation.  Figure 6.3 shows the number of new homes passed by cable networks in the UK each quarter.  After the relaxation of restrictions, following the duopoly review in 1991, cable roll-out accelerated dramatically.  Prior to 1991 an average of 52 446 new homes per quarter were passed, compared with 344 506 in the period after 1991.  The renewed impetus to invest in cable networks was due entirely to telephony.

Figure 6.3:  New Homes Passed by Cable (UK)

Source:  New Media Markets

Further evidence that telephony is the driving force in the cable companies' expansion is offered by Figure 6.4.  By October 1992, when cable companies started to offer telephony, they had a combined pay TV subscriber base of 377 000.  By July 1998 the number of those subscribing to pay TV only was at a similar level, just over 450 000.  Since October 1996, pay TV-only subscribers steadily declined, while telephony-only subscribers doubled to over 1 million in the same period.

Figure 6.4:  Cable Companies' Pay TV and Telephony Subscribers (UK)

Source:  New Media Markets

The ACCC has even acknowledged in a different context that pay TV plays only a minor role in the economic and competitive position of cable networks, even in Australia.  For example, David Lieberman (1997, page 10), a former ACCC Commissioner, has stated publicly that:

While pay TV has a critical short to medium term role in funding the investment required to roll-out the competing cable networks, the roll-out is largely about telephony and broadband services of which Internet services are a prime example.

Are Multiple Revenue Streams Essential?

The ACCC (1997) argued that multiple revenue streams were crucial for the economic viability of broadband cable systems.  To be sure, if a broadband system was built at large expense capable of carrying video, voice and data services in large quantities, it would be foolish to deny that it is useful to have revenue from all sources.  But this is not the issue.  The issue is whether the merger breaches competition law in the sense that any decline in Optus's fortunes can be traced back to FOXTEL gaining enhanced market power as a result of the merger.  The oft-cited dire consequences to, and the threat of withdrawal by, Optus are not necessarily evidence supporting the monopoly claims without first demonstrating that the merger is anti-competitive.  Reference to scenarios from Optus business plans are also not evidence of anti-competitive harm.  Low returns and losses from reduction in forecast lower market shares are entirely consistent with competitive markets:  poor performance results in low profits.

The pull-through argument is essentially a demand-side issue.  On the supply side, there are economies of scope in providing pay TV, telephony and Internet services on the same broadband cable network.  It was suggested that the merger would diminish the economies of scope from Optus's network, thereby raising Optus's costs and decreasing competition.  The economies of scope between pay TV and telephony arise from the common costs which result from the investment in constructing and maintaining broadband cable networks, and, to a lesser extent, in operating and marketing costs. ⁽⁴⁴⁾  However, the inability to reap economies of scope can be regarded as anti-competitive only if the reduced take-up of Optus Vision pay TV resulted from the exercise of enhanced market power by the merged entity.

The ACCC also ignored a counteracting consideration, namely, that because of the addition of telephony revenues a pay TV subscriber is worth more to Optus than Australis.  Optus's ability to bundle pay TV and telephony, together with the ACCC's claim that pay TV was critical to attracting telephony customers, would have given Optus a tremendous advantage.  Optus could have reduced pay TV subscription charges and/or bid higher for pay TV programme rights than its subscriber numbers would justify, as they have.

The ACCC's treatment of cost factors is selective and bifurcated.  The argument that FOXTEL would gain efficiencies from a larger number of subscribers was implicitly dismissed as irrelevant.  On the other hand, the prospect of a decline in Optus's competitive position, which would reduce the realisation of economies of scope, was seen as critical.

Further, Optus stated that if the merger went ahead, it would not invest in a satellite delivery platform to expand its coverage to meet that of Australis, and (more dramatically) that it would withdraw from Australia completely.  The latter threat was not credible.  Moreover, if Optus had decided to sell its business, presumably at a knockdown price, others would have willingly taken over.  While the claim that Optus would not invest in satellite delivery to compete in the non-cabled market may have been commercially justified, it was not credible.  Optus owns the satellite, has immediate access to programming, and can point to no capital market constraints which would limit its access to funds.  This "threat" has no competitive implications per se, and the commercial viability of Optus's satellite business would therefore have been unchanged by the merger.  At the time of writing, Optus was still questioning whether it will launch a satellite business.

CONCLUDING REMARKS

A number of reasons have been offered as to why the proposed merger was unlikely to have substantially lessened competition in either the pay TV or telecommunications sectors.  Simply put, Australis was not an effective competitor in the provision of pay TV.  This was because the Galaxy purchase package of core programming was already broadcast on FOXTEL and, as such, the merger would not have increased the programme offering of FOXTEL or Australis.  As well, because Australis found it could not compete in cabled areas, it withdrew from them.  The outcome was, in some sense, ironic:  Australis could not compete because of government policy, which favoured telephony, and was not allowed to merge because it was viewed as a threat to the viability of the telephony service it did not supply.  The ACCC appears to have protected competitors from competition, rather than competition from monopoly.

The ACCC's approach also raised a more significant question about the benchmark for facilities-based competition and the economic efficiency of the Australian communications sector.  The ACCC's line of analysis pointed to a potentially significant problem about the sustainability of the facilities-based competition between FOXTEL and Optus.  They suggested or implied that there was a strong natural monopoly element in the provision of broadband infrastructure of the type examined in Chapter 4.  If there were major economies of scale and scope, as Optus was alleging, this would point to an uneconomic structure for Australia's broadband cable sector.

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ENDNOTES

39.  Austar and ECTV were at the time "Australis franchisees".  Each delivered Australis's programming to subscribers within its region.  Australis provided a conditional access system and transmission facilities to the franchisees.  In return, the franchisees paid Australis a fixed percentage of their net revenue for the Galaxy package, and a proportionate share of the costs of the Australis conditional access system.

40.  The ACCC's analysis proceeded on the basis that there were only three operators (Australis, FOXTEL and Optus Vision) and dismissed Austar as a competitor, grouping it with Australis.

41.  QCMA (1976) ATPR 40-012 and then Queensland Wire Industries Pty Ltd v BHP (1989) 167 CLR 177

42.  This follows from the economist's standard assumption that demand curves are negatively sloped.

43.  This growth of telephony is unremarkable since it picks up an existing installed subscriber base of pay TV customers rather than new pay TV customers.  Once this effect has worked through, the growth rate of telephony should slow, as has occurred.

44.  In the UK, CWC's new pay-TV access tier costs £9.99 a month and includes telephone line rental, the five FTA channels plus ITV2, UK Horizons, Sky News, BBC News 24, a local channel and a "bonus" channel.  This compares with the £8.87 BT charges for line rental alone (New Media Markets, 1 October 1998).