Will Verizon's Subscriber Base Enable It To Reinvigorate Yahoo?

| About: Verizon Communications (VZ)

Summary

Verizon is counting on its large subscriber base to make a success of its acquisition of Yahoo despite the latter’s repeated failures to adapt to the world of social media.

Limited competition in the US broadband market and weak enforcement of pro-competitive regulations may help Verizon exploit its large customer base to grow Yahoo/AOL-based revenues.

However, historical attempts by large telephone companies to build successful content businesses have failed to overcome internal bureaucratic and cultural obstacles to developing new sources of revenues outside their core.

Verizon's closest peer AT&T is following a different path to building new revenue streams with a stronger emphasis on foreign investments and longer established content platforms.

Verizon (NYSE:VZ) hopes or expects that its 100 million or so subscribers, thanks to their relationships with Verizon as well as the information Verizon possesses on them, will enable it to make a success of Yahoo where others including its current CEO Marissa Mayer have consistently failed.

The notion that telephone companies can make a success of content services and applications and be much more than just pipes is not a new one. For example in an earlier pre-Internet or pre-broadband era in the early 1990s, when cellular communications also was still in its infancy Bell Atlantic (the predecessor core of today's Verizon) pursued the interactive TV market. It hoped to generate revenues from consumers through home shopping and banking by receiving a percentage of the sales that would result from use of its own navigation tool, named Stargazer. It also wished to charge retailers rent for space in its electronic mall. Stargazer became the basis of Tele-TV, a media and technology company formed by Bell Atlantic and two other telephone companies Nynex (also now part of Verizon), Pacific Telesis (now part of AT&T (NYSE:T)) and Creative Artists Agency (CAA) in February 1995. The company intended to offer an interactive TV service with a set-top box. Howard Stringer, CBS chief and president of Sony (NYSE:SNE) was hired as CEO, with former Fox executive Sandy Grushow as president. Michael Ovitz, then head of CAA, was to be the dealmaker between Hollywood and Tele-TV. The company reportedly spent several hundreds of millions of dollars before halting operations in early 1997. The cultures of the old Bell System based on the East Coast did not mesh well with the very different culture of Hollywood, nor did telephone companies demonstrate the ability to divine or shape consumer tastes.

Now Verizon is trying to prove that it can overcome the lumbering bureaucratic legacy of its origins in telephony and is capable of building a sizable and profitable content business in the very different and fast paced Internet and social media-dominated world of today. In this endeavor it has acquired two pioneers of this environment that were riding high in the late 1990s - AOL and now Yahoo - but have been left far behind by later arrivals on the scene, notably Google and Facebook. In other words Verizon hopes to build a strong content play by combining two weak players. Notably both Yahoo and AOL have participated in several unsuccessful acquisitions (AOL/Time Warner most spectacularly) and for Yahoo its purchases of Flickr (in 2005) and Tumblr (in 2013), among others. In contrast Yahoo's investment in the Chinese e-commerce giant Alibaba (NYSE:BABA) has proved to be very lucrative, and is not included in the new deal.

The reasons for optimism about the prospects for Verizon's purchase of Yahoo are the: (1) Financial muscle it can bring to bear (Verizon can absorb losses that would be the death of smaller companies, just like Intel (NASDAQ:INTC) which incurred multi-billion dollar losses from its attempts to become a force in processors for mobile devices), (2) Interest of digital advertisers in having a third sizable platform for online advertising (Google and Facebook reportedly control about 50% of the digital advertising market, while Yahoo and AOL combined only account for 6%), and (3) Verizon's ability to exploit its position in the US broadband oligopoly, for example by exploiting so-called "zero rating" opportunities.

Zero rating selected content downloaded by subscribers does not count against any data caps in the broadband services they use. In contrast to other content, including that which is competitive to zero rated content, may become more expensive if its volume exceeds the data cap. All major US mobile operators including Verizon already make some use of zero rating. It is not clear whether zero rating will be considered as a violation of the net neutrality rules approved by the FCC in February 2015. Moreover the FCC's Enforcement Bureau has shown little sympathy to complaints from entrepreneurial challengers to business practices and behavior of the large broadband operators that allegedly violate FCC rules, most obviously in the case of the FCC's Data Roaming Order of 2011. Hence it is very likely, even if the net neutrality rules ultimately survive all legal challenges, Verizon will be able to use zero rating - and perhaps other stratagems - to build on its subscriber base in ways that increase the value of Yahoo/AOL as a platform for third parties. As a wireless carrier, Verizon possesses considerable information on the locations of its users as well as their behavior and activities on their phones. As a smartphone distributor, Verizon can influence handset manufacturers to include extra apps and software on mobile devices that can specifically support the goals of its content business.

However there also are reasons for skepticism about Verizon's ability to create significant value out of Yahoo/AOL. It does take a lot to move the needle of a $130 billion revenue company. One question mark is whether Verizon can succeed in the environment of social media despite the discouraging history of telephone companies' attempts to diversify into markets with very different success factors than their core business. Notably Verizon, like Yahoo, seems to be following a policy of innovation through acquisition rather than through internal development. This policy has not worked for several leaders with more credentials in innovation and entrepreneurialism that are associated with Verizon. There is little evidence that Verizon can apply the capabilities enumerated above to build sustainable advantages against the powerful and unified distribution systems of social platforms.

Interestingly Verizon has a different emphasis in its development of new revenue streams than its closest peer AT&T, although the latter also was reportedly interested in acquiring Yahoo. AT&T is investing in networks abroad for now mainly in Latin America (notably Mexico) to build new revenue streams as well as in more traditional content platforms (DirecTV). It will be a challenge for AT&T to succeed in markets outside the US. Reportedly its 10-year target is to become the market leader in telecommmunications in Mexico, overtaking the well entrenched dominant leader Telcel (America Movil (NYSE:AMX)). Prior to the fundamental reform of the telecommunications market by the current Mexican Government that effectively opened the door for entrants AT&T was a partner of America Movil. Progress and profitability in markets outside the US will require the mentality of a new entrant or challenger unless AT&T buys into an incumbent as its predecessor SBC did in South Africa. This mentality is very different from AT&T's tradition, culture and modus operandi as a privileged incumbent relying on a powerful, intimately entrenched and long standing position within circles of political, regulatory and financial influence.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have supported small companies in their opposition to and complaints about the practices of large US broadband operators before the FCC.

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