COMPETITION AND MERGER ACTIVITY IN THE U.S. TELECOMMUNICATIONS INDUSTRY

• Date: 01 March 2018
• Author: Robert Loveland,Kevin Okoeguale
• Published date: 01 March 2018
• DOI: http://doi.org/10.1111/jfir.12138

COMPETITION AND MERGER ACTIVITY IN THE

U.S. TELECOMMUNICATIONS INDUSTRY

Kevin Okoeguale

Saint Mary’s College of California

Robert Loveland

California State University, East Bay

Abstract

In this article we examine the U.S. telecommunications industry during a period of rapid

deregulation to determine the effects of a deregulatory shock on industry competition

and merger activity. We show that merger activity exhibits a clear wave-like pattern,

regardless of the listing status of the participants. Increased competition and IPO activity

following deregulation increased cash-flow volatility and probability of exit while the

introduction of new technology increased dispersion of economic efficiency across the

industry. These changes resulted in a significant increase in merger activity.

Competition also played an important role in shaping “who buys whom?”

JEL Classification: G34, G38

I. Introduction

The merger literature provides extensive empirical evidence to support the finding that

corporate mergers

1

cluster by industry and time (Mitchell and Mulherin 1996; Andrade,

Mitchell, and Stafford 2001; Harford 2005). Neoclassical theory, on the one hand, views

these merger clusters, or “waves,”as the mechanism through which industries reallocate

assets, on a large scale, to more efficient users in response to an industrywide economic

shock. Behavioralfinance theory, on the other hand,argues that relative stock misvaluation

is the primary driver of merger waves (Shleifer and Vishny 2003; Rhodes-Kropf,

Robinson, and Viswanathan2005), while also acknowledginga role for industry shocks in

initiating the wave (Rhodes-Kropf, Robinson, and Viswanathan 2005, p. 600).

However, comparatively little work has been devoted to understanding how

these forces form concentrated merger waves. Harford (2005) shows that in addition to

the economic shocks that initiate the wave, capital liquidity is needed to provide

sufficiently low transaction costs to allow for merger waves to propagate. Maksimovic,

We thank Stuart Gillan, James Linck, Harold Mulherin, Jeffry Netter, Annette Poulsen, seminar participants

at the University of Georgia and Saint Mary’s College of California, and conference participants at the 2012

Southern Finance Association meetings, 2013 Financial Management Association meetings, and 2013

Australasian Finance Banking Conference, for helpful comments, suggestions, and discussions. We are also

grateful for the comments of an anonymous referee.

1

We use the term “mergers”to refer to both mergers and acquisitions.

The Journal of Financial Research Vol. XLI, No. 1 Pages 33–65 Spring 2018

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© 2018 The Southern Finance Association and the Southwestern Finance Association

Phillips, and Yang (2013) find that firms with higher productivity and better access to

capital markets participate more in acquisition waves. Other studies suggest that

coincident factors such as cash-flow volatility (Garfinkel and Hankins 2011) or

heterogeneous industry risk (Loveland and Okoeguale 2016) are partially responsible for

the propagation of merger waves.

To determine how industry change drives mergers, we use data from the U.S.

telecommunications (telecom) industry to empirically document the manner in which

industry shocks drive merger activity. In particular, we examine the role of competition

in driving industry mergers. To do so, we use a large sample of public and private

mergers, along with industry and firm-level data, to provide a detailed depiction of the

industry preceding, and industry dynamics following, a regulatory shock: passage of the

1996 Telecommunications Act (the Act).

The 1996 Act was a sweeping overhaul of the telecom industry, intended to

foster increased competition in order to promote the development of new services in

broadcasting, cable, telecommunications, information, and video services. The Act

opened the markets for local and long-distance phone services to entry and competition

from new communication technologies, removing previous product and geographical

boundaries set by law. The passage and implementation of the Act sparked a

transformation of the telecom industry, notable for the multitude of new entrants to the

marketplace, numerous industry exits through takeover or failure, and rapid expansion of

the industry.

The U.S. telecom industry provides an excellent setting to study the effect of

industry change and increased competition on mergers because the industry experienced

several structural shocks via deregulation and technological change over the sample

period (Weston, Mitchell, and Mulherin 2004), and its large, capital-intensive public

firms were subject to several bull markets (mid-1980s, 1990s, and mid-2000s) that

provide fertile ground for possible misvaluation. Moreover, the study of this single

industry allows us to focus on the specific channel that alters firm-level characteristics in

response to industry-level change.

We find that acquisition activity in the U.S. telecom industry exhibits a clear

wave-like pattern in the years following passage of the Act, regardless of the public/

private status of the acquirer or target. This evidence is consistent with the extant

literature (e.g., Mitchell and Mulherin 1996; Harford 2005); however, our finding that

private acquirers exhibit more acquisition volatility than public acquirers is inconsistent

with recent evidence that demonstrates public acquirers generally exhibit more extreme

wave-like clustering than private acquirers (e.g., Netter, Stegemoller, and Wintoki 2011;

Maksimovic, Phillips, and Yang 2013). We also find that deals involving public acquirers

and targets are representative of the population of telecom merger deals during the

period. Given this finding, we next examine the competitive dynamics of the telecom

industry using a panel data set of public deals.

We find that deregulatory changes to industry structure had several important

effects. The changes: (1) spurred IPO activity, thus decreasing the concentration of large,

publicly traded firms and resulting in a more heterogeneous set of firms industrywide;

(2) increased firm-level cash-flow volatility and simultaneously decreased correlation

among firm-level cash flows, thus increasing the probability of exit; and (3) increased the

34 The Journal of Financial Research

dispersion in firm-level economic efficiency across the industry (the result of

technological innovations that lowered the cost of providing telecom services for

firms that invested in emerging technologies (Beker 2001)). These changes are

positively associated with increases in the level of merger activity following

deregulation of the industry, consistent with predictions of industry shocks theory.

Collectively, these findings are also consistent with evidence in the literature that

mergers play an expansionary as well as contractionary role (e.g., Andrade and

Stafford 2004). Finally, we find that as merger activity increased following passage

of the 1996 Act, stock misvaluation declined, a finding inconsistent with predictions

of misvaluation theory.

Analysis of firm-level characteristics shows that pre-deregulation size and

profitability/efficiency characteristics are important determinants of who survives

versus who exits the industry via merger or bankruptcy. In the more competitive

post-deregulatory environment, smaller and less efficient incumbents are not targeted for

acquisition but are instead left to face exit via bankruptcy or nonvoluntary delisting.

However, ex ante levels of efficiency and leverage are important in determining which

firms become acquirers and which become targets in mergers of industry incumbents; the

more efficient and less levered incumbents are more likely to be acquirers in intraindustry

mergers.

We contribute to the merger literature in several ways. First, we demonstrate that

changes to the competitive structure of the telecom industry following deregulation in

1996 resulted in a significant increase in industrywide merger activity, regardless of the

public/private status of the participants. Second, we show that competition plays an

important role in shaping “who buys whom?”Fatter and fitter firms are more likely to

survive and become acquirers in intraindustry mergers, whereas smaller and less efficient

incumbents are not targeted for acquisition but, rather, are left to face exit via bankruptcy

or nonvoluntary delisting. Collectively, the evidence presented in this article

demonstrates that competition is an important channel though which industry change

drives an industry merger wave. We show that in the U.S. telecom industry, mergers

facilitated the reallocation of resources within the industry to the most efficient users in

response to increased competition brought about by deregulation and technological

change. This evidence thus affirms the link among deregulation, competition, and merger

activity.

II. U.S. Telecommunications Industry

Brief History of the U.S. Telecommunications Industry

The telecommunications industry in the United States has historically been subject to

heavy regulation. By the very early part of the 20th century, AT&T dominated the

industry through ownership of the great majority of telephony exchanges in the country

(Economides 1999). At the time, the telecommunications market was viewed as a natural

monopoly in which competition was not possible; thus, regulation was used to protect

customers from abuse by the monopoly supplier. Regulation was initially instituted at

Competition and Merger Activity 35