Despite recent broad declines, the capital markets continue to embed substantial long-term growth expectations in the valuations of the major media conglomerates (Exhibit 1). Indeed, for large media groups, between 55 and 75 percent of their valuations at the end of June could be attributed to growth anticipated from activities that are not reflected in their current business or in analysts' expectations. This compares to 47 percent on average for the S&P 500.

One explanation for current valuations is that although the media industry is enduring a down cycle, the sector has historically created considerable value for shareholders. Encouraging signs like the strong Hollywood summer box office and the growth of broadband Internet access suggest continued potential for the industry. And even though the advertising market is in its worst recession since the 1930s, many investors are familiar with the rapid upside that well-positioned media companies can experience when advertising rebounds.

Nevertheless, the near- and midterm challenges of performing at a level necessary to rationalize current valuations are significant. For example, one familiar media company with earnings per share (EPS) projected to grow to about $4.00 between now and 2006 would have to increase expected EPS in 2006 from about $4.00 to about $8.50, all else being equal, to justify its valuation (Exhibit 2).

It is unlikely that current capital market expectations can be met by organic initiatives alone, especially in an industry hampered by the tremendous disruption of new digital technologies, a changing regulatory framework, and a challenging capital markets environment. Indeed, in the previous example our analysis suggests that only half of the $4.50 gap between the company's current trajectory and the expectations built into its share price can be closed through best-case operational improvement and organic new business development.

In the end, a combination of levers is likely to be necessary. Operational improvements and organic business growth will continue to be critical, but a carefully constructed and strategically rational merger, acquisition, and divestiture program must be included. First movers may well have an advantage. Despite the challenges, capital markets are likely to reward conglomerates that act quickly to implement such a program in an orderly and effective way. Others may be forced into a rapid restructuring later that is less desirable for management teams and shareholders alike.

The reality of M&A in media and entertainment

In some ways, mergers and acquisitions in media and entertainment may be handicapped by the industry's own self-image. A tide of activity in this sector over the past decade has prompted wide-ranging comment from the press, investment analysts, and other commentators, out of which has evolved a dangerous consensus that there is something unique about value creation through M&A in this industry. It is perceived that media and entertainment is somehow different from other industries, enjoying a mysterious immunity from the fundamental rules of capital markets, finance, and strategy.

Our research, however, reveals a different story. We analyzed the value creation performance through mergers and acquisitions (in terms of stock price movements of both acquirer and target) for the 400 largest media and entertainment company transactions in the United States since 1990. We concluded that, in fact, the normal rules of economics and value creation do apply to the media and entertainment industry; we also found significant evidence to debunk the most common misperceptions that exist within the industry (Exhibit 3).

For example, one of the most repeated beliefs among media and entertainment company executives is that they typically overpay for assets acquired. On the contrary, the evidence of the past decade suggests that from the perspective of acquirers, media and entertainment companies create more value on average than acquisitions in other industries. In fact, 54 percent of media and entertainment deals created value for the shareholders of acquirers and 81 percent created value for the shareholders of sellers. This compares with M&A deals across all industries, which created value for 42 percent of acquirers and 91 percent of sellers.

Another misperception is that deals focusing on forward integration across adjacent value chain elements are more likely to create value than consolidation or backward integrative deals—for example, that a company would create more value by acquiring distributors than in acquiring suppliers. In fact, the evidence suggests that transactions that involved integration backward in the value chain have been more successful than either forward integrative deals or those focused on consolidation in one part of the value chain. Indeed, distributors acquiring content have been more successful at creating value than content players attempting to move into distribution. Acquirers in backward integrative deals have created value 64 percent of the time and in consolidation plays, tracking average overall success rates, 54 percent of the time. In comparison, only 40 percent of forward integrative deals created value for acquirers.

Furthermore, conventional wisdom holds that large "industry shaping" deals have generally been the most successful. In fact, acquirers have been significantly less successful in large acquisitions—66 percent of deals under $5 billion created value for the acquirer's shareholders compared with only 33 percent of deals over $5 billion. This could be due to the fact that larger deals have more significant integration and synergy-capture difficulties, such as the inclusion of significant nonsynergistic or unwanted assets and business units. It is also the case that acquisitions of individual business units have been considerably more successful than acquisitions of whole companies: 66 percent of business unit acquisitions have created value for the acquirer compared with only 50 percent of full corporate acquisitions. This is likely to be the result of a greater focus on clearly synergistic assets in the case of business unit purchases.

So, media and entertainment companies can do quite well as acquirers compared to US corporations as a whole, particularly when they avoid some conventional wisdom common to the industry. These analyses, linked to the significant expectations embedded by the capital markets in the stock prices of the largest media conglomerates, offer a very important set of implications.

Managerial implications

It would obviously be naive to think that mergers, acquisitions, and divestitures are an easy answer to all ills, but the evidence suggests that transactional activity will be a necessary catalyst to the creation of new sources of value. It will, however, be critical to supplement mergers and acquisitions with selective divestiture. Overly diversified media conglomerates with nonsynergistic asset holdings may have to restructure and divest before the capital markets afford them the opportunity to acquire. To establish a starting point, CEOs and CFOs in media enterprises must answer three key questions:

What is the gap between what a company is expected to deliver and what it can deliver given its current asset portfolio? Answering this question involves developing a clear understanding of the performance expectations built into the stock price by the capital markets. Expectations have to be quantified in earnings terms with a hard look at where such anticipated performance improvement is likely to come from given the current business portfolio and any "gap" analyzed objectively. In our experience, many companies do not clearly understand the nature and magnitude of such expectations gaps. The example in Exhibit 2 demonstrates the initial steps in this process. The resulting EPS gap compared to aspirations can then be disaggregated into business unit-level targets for operational improvement, revenue growth, and new business development as a mechanism for aligning shareholder value creation expectations with specific business unit targets.

How can a company discover real synergies and emerging sources of value and integrate them into its M&A program? This process involves closely evaluating the existing capabilities of each business unit and then mapping the results to a company's business portfolio. The overlay between the two will highlight capability combinations that could produce incremental sources of value, including new businesses, additional opportunities in existing businesses, cross-selling to existing customers, and so on. It should also illuminate any gaps in existing capabilities that should form the basis of an external search for opportunities, in both existing and adjacent businesses. Our research has shown that corporations that take this type of proactive approach and adhere to best practice in corporate scope management can outperform their industry average by two to three percent, measured by total return to shareholders, each year.¹

Is a company currently holding assets that are no longer of core relevance, assets that can be divested to create shareholder value and free up resources for growth? Our research and work in the industry have indicated that most media and entertainment companies pay significantly more attention to acquisitions than to divestitures. The few divestitures that are completed are typically in response to pressure from capital markets as a result of poor performance rather than to a proactive program of portfolio management. Our work also suggests that an active and balanced approach to acquisitions and divestitures leads to strong performance in the capital markets.² Given the broadly diversified portfolios held by many media and entertainment conglomerates today, and their poor recent capital markets performance, we believe that there is substantial potential to create value from a thorough reevaluation of portfolio breadth.

The managerial agenda, therefore, is quite straightforward. Our analysis and experience with large media and entertainment companies suggest that the scale of expectations and the associated operational implications given existing asset configurations are very poorly understood. And while industry CEOs regularly contemplate merger and acquisition activity, they typically give less consideration to the value creation potential of proactive divestitures and asset portfolio restructuring—two components of successful M&A programs that will be critical to out-performance over the next several years. Our experience in this industry suggests that there is a lot of value left to create but that more radical, step-out asset moves, perhaps in the face of the accepted wisdom, will be necessary. Future leaders of media businesses will be those companies that are not afraid to fundamentally rebalance their portfolios as a starting point for this journey.