Estimating the Effects on Productivity and Costs of US Telecommunications Mergers

Transcription

1 ITS European Conference 2003 Estimating the Effects on Productivity and Costs of US Telecommunications Mergers Nakil Sung Assistant Professor The University of Seoul Faculty of Economics 90 Cheonnong-dong, Dongdaemun-gu, Seoul, , Korea (Tel) (Fax) ( ) * This paper is the very first draft. Please do not quote the paper without the author s permission. 1

2 ABSTRACT The paper attempts to examine the effects of two horizontal mergers between Baby Bells, the SBC-Pacific Telesis merger and the Bell Atlantic-Nynex merger, on the performance of respective operating companies. The effects of the mergers are investigated by comparing the performance of the merging companies with control group of non-merging companies and also, the performance of the merging companies before and after mergers. The comparisons are made on shareholder s return, total factor productivity (TFP) change and shifts in total cost function. In addition, the estimation of total cost functions provide the estimates for economies of scale and scope, which are often cited as one of main drivers for mergers. The empirical analyses are carried out with annual data for 38 operating companies over the period One of the main results is that merged holding companies outperformed non-merged companies in a short-period but this small gain disappeared soon. Also, there is no significant increase in TFP for merged companies before and after mergers and also, no systematic difference in TFP between merged and non-merged companies. The TFP regressions show that mergers might have a negative or no impact on TFP. Moreover, the cost analysis indicates that mergers might even increase total costs. We control for demand fluctuations, the state of technology and two policy variables (regulation and competition) in both productivity and cost analysis. Finally, no peculiar change in economies of scale and scope is identified. Based on all these findings, the paper suggests that mergers between big Baby Bells are unlikely to benefit from economies of scale and do not lead to substantial productivity growth. They do not play even a role of catalyst for cost cutting or restructuring. Keywords: Merger; Total factor productivity; Cost function; Economies of scale JEL Classification: L11; L96 2

3 1. Introduction In 1997, Bell Atlantic submitted a petition to the New York Public Service Commission seeking approval of (or, technically, nonintervention in) the proposed Bell Atlantic-Nynex merger. 1 Among the arguments in favor of the merger was that it would achieve a minimum of $600 million in annual cost savings through operating efficiency and economies of scale and scope. The basis for this estimate was not made explicit but it is consistent with predictions of savings from other mergers in the telecommunications industry and, frequently, from proposed mergers in manufacturing. Regulators, including the Federal Communications Commission (FCC), supported the argument that these benefits from mergers between Baby Bells exceeded their costs, i.e. diminution in actual and potential competition. Accordingly, the Bell Atlantic-Nynex merger was approved on August, 1997, just after consummation of the merger between two other Baby Bells (SBC Communications and Pacific Telesis). Within less than three years after these mergers, SBC Communications and Bell Atlantic Corp acquired Ameritech Corp. and GTE Corp., respectively, again. Currently, there are only four Baby Bells left in the U.S. local telecommunications markets. More importantly, contrary to the view that mergers between Baby Bells would promote additional competition in many telecommunications market, it seems that the U.S. local telecommunications markets are not still sufficiently competitive. This study attempts to answer the following questions: Did merged companies perform better than before and than non-merged companies? Were the cost savings realized as promised? In particular, the study analyzes the effects of the first two horizontal mergers 1 Proceedings before the State of New York Public Service Commission, Case 96-C-0603,

4 between Baby Bells, the SBC-Pacific Telesis merger and the Bell Atlantic-Nynex merger, on the performance of respective local operating companies, so-called regional Bell operating companies (RBOCs). The effects of the mergers are examined by comparing the performance of the merged companies with control groups of non-merged companies and also, the performance of the merged companies before and after mergers. In this sense, the study is a dynamic analysis of mergers. 2 The comparisons are made on shareholder s return, total factor productivity (TFP) change and shifts in total cost function. In addition, the estimation of total cost functions provides the estimates for economies of scale and scope, which are often cited as one of main drivers for mergers. The study is different from previous studies on mergers in that it attempts not only to measure value creation (or destruction) resulting from mergers but also to determine whether the expected capital gains are actually realized. Also, the study attempts to improve on the evidence arising from accounting measures of profitability, such as return on assets and operating income, by examining more detailed information on productivity and efficiency change. In the U.S. local telecommunications markets, the effects of mergers on the performance of operating companies have been often mixed up with those of other policy factors, including regulatory regime and competitive pressures. For example, several types of incentive regulation, especially price-cap regulation, have been introduced in many states since early 1980 s through 1990 s. Obviously, incentive regulation may have beneficial influences on 2 Berger, Demsetz and Strahan (1999) divide the research literature on the consequences of consolidation into static and dynamic analyses. Static analyses are defined as studies that relate the potential consequences of consolidation to certain characteristics of financial institutions such as institution size. Dynamic analyses are defined as studies that compare the behavior of financial institutions before and after mergers and acquisitions (M&As) or compare the behavior of recently consolidated institutions with other institutions that have not recently engaged in M&As. 4

5 the performance of local operating companies. Also, several competitive local exchange carriers entered local telecommunications markets, especially after enactment of the U.S. Telecommunications Act It is well-known that one of the major objectives of the Act is to encourage local competition. Thus, local competition may exhibit disciplinary effects on local operating companies as well, although these may not be substantially big. Therefore, careful consideration should be given to both regulatory and competitive effects in order to identify the effects of mergers on the performance of local operating companies. The paper proceeds as follows. In the following section we examine the response of respective shareholders to mergers under investigation by using stock price data from the Center for Research in Security Prices (CRSP) database. Section 3 presents TFP changes for merged and non-merged companies and examines the reasons for difference in the TFP changes. In section 4, we estimate total cost function to examine the effects of mergers on cost cuts in local operating companies. Conclusions are drawn in the final section. 2. U.S. Telecommunications Mergers and Stock Market Reaction 2-1. Costs and Benefits of Local Telecommunications Mergers In terms of merger activity, telecommunications are one of the most active industries in the 1990s. Until the mid-1990 s the usual pattern of mergers in the U.S. telecommunications industry was to combine two companies operating in different markets: for example, acquisition of NCR and McCaw Cellular Communications by AT&T Corp. in 1991 and in 1994, respectively, and acquisition of Time Warner Entertainment by US West in The 3 For detailed explanations on telecommunications mergers in the early 1990 s, refer to Ferris and Park (2001). They analyze the long-run performance of acquiring firms in the U.S. telecommunications industry for the period , based on a typical event study. For their sample period, vertical and conglomerate mergers were more common than horizontal 5

6 main potential benefits of these mergers were the achievement of scale effects through consumer base and scope effects through convergence or vertical integration. On the other hand, as shown in Table 1, mergers between big regional or local holding companies operating in their own nearly monopolistic markets became more frequent the late 1990 s. The prospect of intense local competition, motivated by the Telecommunications Act 1996, might lead to active merger activities in the U.S. local telecommunications markets. 4 Technological progress, in which has shifted a cost function and encouraged new entries in the local telecommunications markets, might create new opportunities for mergers. In any case, it is obvious that horizontal mergers between local holding companies, especially between Baby Bells, result in increase in market power of a combined company by eliminating potential competitors and intimidating actual competitors. On the other hand, mergers would transform a combined company into a national and global carrier capable of meeting the full range of customer s needs, which might lead to increased revenues for the company. Also, mergers would result in significant cost savings, which are mainly attributed to the effects of scale and scope or often to their role as catalysts for cost-reducing organizational change. Both revenue increase and cost reduction imply faster productivity growth for a combined company. 5 mergers. One of their major findings is that the acquiring firms under-perform their size and industry matched control firms. Using stock data, Lys and Vincent (1995) show that AT&T s acquisition of NCR decreased the wealth of AT&T shareholders by between $3.9 billion and $6.5 billion and resulted in negative synergies of $1.3 to $3.0 billion. 4 Deregulation is one remarkable example of unexpected shocks to industry structure, to which mergers may occur as a reaction. Andrade et al. (2001) show that deregulation becomes a dominant factor in merger and acquisition activity after the late 1980s and accounts for nearly half of the merger activity since then. Trillas (2002) indicates that deregulation of telecommunications in Europe contributes to a change in the ownership structure of European telecommunications firms. 5 The hypotheses on the reason for mergers can be classified into two broad categories. The first category of hypotheses presumes that the managers of the merging companies attempt to maximize profits or shareholder value. For example, any merger is expected to either increase in the market power of the merging companies or reduce their costs. The second 6

7 These benefits from mergers, however, are often questionable, while the costs of the mergers are obvious. As a result, identifying the presence of the cost savings before and after mergers is the task we selected for this paper. The emphasis should be put on the fact that the cost-reducing organizational change, e.g. restructuring efforts of a combined company, should not be regarded as merger-specific benefits because equivalent cost reduction could be achieved by mechanisms other than mergers. Thus, if there are no or little remarkable difference in both productivity growth and cost shifts between merged and non-merged companies, then the chance that the mergers are in the public interest is rare Stock Market Reaction to Telecommunications Mergers Before carrying out productivity and cost analysis, we present capital gains of merged companies shareholders. 6 This analysis is supplementary to productivity and cost analysis because the former provides information on market power of a combined company and the latter can not. Or the productivity and cost analysis are able to disentangle efficiency changes from changes in market power which may be incorporated into capital gains. Increase in market power as well as productivity improvements is beneficial for shareholders category of hypotheses argues that mergers do not result from profit maximization. For example, mangers over-estimate their ability and overpay for a target company (hubris hypothesis) or undertake mergers for empire-building purposes. The paper focuses on the test on the first category of hypotheses. 6 The paper is different from typical event studies in that it does not present the estimates of abnormal return for merged firms. Interpretation of event studies is subject to a number of well-known problems, including the possibility that information may have leaked prior to the M&A announcement or that markets may anticipate M&As prior to their announcement (Berger, Demsetz and Strahan, 1999). In particular, in telecommunications industry, longterm abnormal performance may not result from mergers, per se, but from all types of corporate events, especially change in regulatory schemes or in the number of competitors. Obviously, these policy variables have effects on the expectation of a regulated company s shareholders. Therefore, we use the calculation of capital gains only as supplementary analysis 7

8 of merged firms, although it is socially inefficient. Accordingly, if we find no systematic difference in productivity growth and cost reduction between two groups but positive response of merged firms shareholders, then we can conclude that the latter took place mainly due to the expectation of market power increase. As shown in Table 2, SBC and Bell Atlantic announced their plan to acquire Pacific Telesis and Nynex on April 1 and 22, 1996, respectively. Following the conventional wisdom, we choose about 60 days before merger announcements, i.e. February 1, as the base date for the calculation of capital gains. Table 3 presents capital gains of local holding companies in 1996 and The dates for the comparisons are selected based on major events specified in Table 2: for example, April/14/1997 is the date when the SBC-Pacific Telesis merger was approved by the FCC. The capital gain of a local holding company s shareholder is defined as return per share Pt? P0? D (r ). r is computed by r?, where P t and P 0 refer to stock price at P 0 respective date and at the base date (February 1, 1996), respectively, and D to the sum of dividends per share between the two dates. That for a target firm s shareholder after a Pt? E? P0? D? DC? E merger is calculated by r?, where E refers to the exchange rate P 0 of a target firm s to an acquiring firm s common stock and DC to the sum of dividends (per share) paid by a combined firm to the target firm s shareholder. Average return per share for an imaginary combined firm before a merger is computed by averaging an acquiring company s and a target company s return per share, with weights being the number of common stocks. One of the interesting findings in Table 3 is that four merged Baby Bells performed better than three non-merged Baby Bells and GTE for the period after the merger announcements and before mid For example, the average capital gain of the merged Baby Bells on 8

9 August/1/1996 is -2.7%, while that for the non-merged Baby Bells and GTE is -3.5% and - 5.9%, respectively. On the other hand, the average capital gains of independent companies, whether some outliers are included or not, are greater than those for the merged Baby Bells. Considering that independent companies are usually much smaller than Baby Bells and GTE, this finding does not contradict with the above one because the size of a firm often affects its performance in terms of stock prices. When only the capital gains of local holding companies with a similar size are compared, it seems that merged firms outperformed nonmerged firms at least in a short period. Again, this positive return for merging companies shareholders may be due to proposed cost savings or to anticipated increase in market power. A number of previous studies on stock market indicate that there is dispersion in the capital gain between acquiring and target companies. The same is true for this study. As shown in Table 3, the average capital gains of acquiring companies, i.e. Bell Atlantic and SBC, are always lower than those for target firms, i.e. Nynex and Pacific Telesis, and also, even lower than those for control group of operating companies. In other words, acquiring companies shareholders did not benefit from the mergers. This confirms a well-known empirical result in the previous studies that any benefit from a merger often comes from target firms capital gains. When we extend the same analyses to a longer period, the above results are not true any more. Table 4 shows a change in the average capital gains of the same companies for six years after the merger announcements. According to Table 4, the short-term beneficial benefits from the mergers to shareholders disappeared with the lapse of time. There were nearly no difference in the average gains between merged Baby Bells and non-merged Baby Bells for this period. This may happen due to many corporate events involved in the history of the sample companies or because the effects of market power increase on shareholder s return were gradually offset by those of unrealizable cost savings or productivity growth. 9

10 The second effects are examined in detail from now on. 3. Growth in Total Factor Productivity 3-1. Calculating TFP Growth Rates The empirical analysis is carried out with pooled cross-sectional time series data for 38 operating companies: 13 merged companies and 25 non-merged companies. The primary sources of company data were the Statistics of Communications Common Carriers and the Automated Reporting Management Information System (ARMIS) data in which local companies file financial and operating data to the FCC. Annual data for the local operating companies were collected for the period Table 5 provides a list of the 38 companies, while the appendix gives an detailed explanation on the method used to measure inputs, outputs and a technology variable. For measuring TFP, we first aggregate two outputs (access lines and telephone calls) and three inputs (labor, capital and materials). For the capital inputs, we use alternatively net and gross capital stock. A translog multilateral index of TFP is then calculated using the method of Caves, Christensen and Diewert (1982). Table 6 shows a change in the average annual growth rates in TFP for merged and nonmerged companies before and after the mergers. For both the gross and net versions of capital stock, there is no significant increase in TFP for merged companies before and after Moreover, on the average, non-merged companies experience a higher growth rate in TFP than merged companies for the post-merger period In particular, the 7 The sample companies were selected out of many reporting companies because they continued to report their data to the FCC without interruptions for the sample period. Also, the sample period was chosen because of lack of several important operating statistics for the period before 1991 and after

11 average annual growth rate in TFP is 3-4 times larger for non-merged companies in 2000 than for merged companies. The TFP growth rate of independent companies is higher than that for RBOCs in all years after Considering that independent companies are usually much smaller than RBOCs, it appears that the size of a company may have a negative effect on the productivity growth of local operating companies. 8 The calculation of TFP requires the construction of capital stocks in which many problems are involved. Thus, labor productivity changes are examined in order to confirm the robustness of the above findings. Table 7 presents the average annual growth rate in labor productivity, measured by either access lines per employee or telephone calls per employee, for merged and non-merged companies. These indexes are the two widely used measures of labor productivity in telecommunications industry. As shown in Table 7, the growth rate in labor productivity exhibits fairly similar patterns to that in TFP. There is no significant increase in labor productivity for merged companies before and after In particular, when telephone calls per employee are used as a measure of labor productivity, merged companies experience much lower growth rate in labor productivity than non-merged companies in all years after Also, on the average, independent companies enjoy higher labor productivity growth than RBOCs, whatever measures are used TFP Regressions In addition to mergers, many other factors, including scale effects, technological advance, competitive pressure, regulatory scheme etc, may have effects on the productivity of local operating companies. Thus, the TFP regressions control for these factors in order to confirm 8 Gugler et al. (2003) show that mergers between small firms are efficiency enhancing while mergers between large firms would be more likely to increase market power. Mergers between small firms are more likely to increase efficiency by creating economies of scale and scope. 11

12 the merger effects in a strict sense. The basic estimating equation for Table 8 is: lntfp?? 0?? 1DF?? 2 ln PL?? 3 lnth?? 4 ln AL?? 5 ln BS??? COM?? REG MER? (1) where DF refers to demand fluctuation, PL to real wage rate measuring labor quality, TH to capital quality, measured by fitted average vintage, AL to average sheath km of cable per access line, and BS to ratio of business to residential access lines. DF is measured by actual minus predicted output level, with the latter being based on the quadratic time trend. Both AL and BS represent firm-specific characteristics. In general, AL is higher and BS is lower in rural areas than in urban area. In the above equation, MER, COM and REG refer to three policy variables, i.e. merger, competition and regulatory effects, respectively. We use two merger variables; one is a simple dummy variable (MER1) that equals 1 for merged companies in all years after 1996 and otherwise equals 0. The other variable is the number of years passed after a merger (MER2). We use the latter in order to consider the effects of other Baby Bell mergers, which are not captured by the former. 9 COM is proxied by the number of local service competitors. 10 Finally, REG, another dummy variable, equals 1 for the case that a state 9 For example, MER1 and MER2 are equal to 0 and 2, respectively, for Illinois Bell (Ameritech s operating company) in FCC(1999, 2000a, 2000b, 2001) reports several indexes of local competition: for example, the number of reporting local exchange carriers (LECs), end-user lines served by incumbent LECs and competitive LECs, lines provided by large incumbent LECs for resale or local loop unbundling etc. However, as the FCC reports exactly indicate, there is no perfect measure of local competition. Moreover, most indexes are unavailable for the sample period except for the number of local service competitors. In the paper, the numbers of 2000 were extrapolated because of lack of data. Ai and Sappington (2002) measure local competition by the ratio of the state s telephone numbers assigned to either 12

13 introduced any type of incentive regulation in a specific year and is equal to 0 for the case that a state continued to adopt traditional rate-of-return regulation. 11 In the case of a multi-state operating company, the dominant form of regulation is regarded as their regulatory scheme. The estimation is carried out by using a Prais-Winsten procedure in order to take autocorrelation between error terms into account. The concept of gross capital stock is used in the TFP regressions mainly because it permits an estimate of the effects on TFP of changes in the quality of capital inputs Estimation Results Table 8 provides the estimation results from the TFP regressions. In Table 8, models (1) and (2) exclude the two technology variables, i.e. lnpl and lnth, while models (3) and (4) include both of them. In other words, the state of technology is an endogenous variable in the first two models, which indicates that other coefficients, including the coefficient of a merger variable, can capture a part of technology-induced TFP growth. These models are competitive access providers or competitive LECs to the corresponding number assigned to the regional Bell operating companies. Obviously, the number of local service competitors is highly correlated with their measure. Another option of measuring local competitiveness is the use of a dummy variable which equals 1 for the post-competition period. On the other hand, when the competition dummy variable was used, there were no major changes in the empirical results. 11 The form of regulation for basic services provided by major LECs changed from rateof-return regulation or its variants to incentive regulation, especially price cap regulation or its variants, in many states throughout late 1990 s. On the other hand, as of 2000, rate-ofreturn regulation is still adopted in 13 states: Alaska, Arizona, Arkansas, Colorado, Hawaii, Idaho, Minnesota, Montana, New Hampshire, New Mexico, Oregon, South Carolina, Washington. For detailed explanations on state regulatory policy, refer to Abel and Clements (1998) and the National Regulatory Research Institute website. 12 On the other hand, the use of a net capital stock does not affect the main results. 13

14 required because the three policy variables affect TFP not only directly but also through their impact on the state of technology. As shown in Table 8, it appears that most parameter estimates are consistent with a priori theoretical expectations. The coefficients of DF are always positive and statistically significant in every model. That is, an increase in demand shows a positive relation to TFP growth. The coefficients of labor and capital quality have a positive sign and are statistically significant, which seems reasonable results. lnal has negative and statistically significant coefficients, which indicates that average cable length per access line has a negative effect on TFP. In other words, the more densely subscribers are distributed, the higher the productivity of an operating company is. Clearly, this result is expected because the operating company enjoys economies of density. On the other hand, the parameter estimates of lnbs indicate that the portion of business-oriented operation in an operating company does not have a statistically significant effect on the TFP of the company. The coefficients of COM are always positive and statistically significant, while those of REG have a positive sign but are not statistically significant. That is, as an operating company faces more competitors in local markets and operates under any type of incentive regulation, its productivity tends to increase. The regulatory effects, however, is not clear. Among policy variables, the merger variables exhibit the worst performance. The coefficients of MER2 are positive but statistically insignificant. Moreover, the coefficient of MER1 is negative in both models and statistically significant in model (1). One participant into a merger experiences productivity improvements, while the other suffers productivity losses, making the net change for the combined company essentially zero. Despite the cost savings arguments suggested by merging firms, it seems that the mergers had no positive effects on the productivity of the combined firm, with other variables being controlled for. 14

15 4. Mergers and Shifts in Cost Functions 4-1. Empirical Specification of a Cost Function We now examine the effects of mergers on shifts in the cost functions of local operating companies. The presence of positive merger effects is tested by introducing a merger variable as an additional explanatory variable in the cost functions. Assuming long-run equilibrium, the cost structure of local operating companies is represented by the following total cost (TC) function. lntc? g(lnq1,lnq2 ;lnpl,lnpm,lnpk ; lnth,ln AL,lnBS ; MER, COM, REG ) (2) Here, two output variables, Q 1 and Q 2, refer to access lines and telephone calls, respectively, PM to real material prices, and PK to real rental prices. The other variables are defined as the same as before. Then, g(.) is approximated by a conventional translog format except that three policy variables have only the first-order terms. For translog estimates, normalization of all variables by sample means permits that the first-order terms to be interpreted as the elasticities at the sample means. The estimation is carried out by combining a Prais-Winston procedure with Zellner s seemingly unrelated regression technique. First, the first-order serial correlation in error terms is assumed, due to the time-series property of the data. For the proper identification of autoregressive coefficients, we impose the restriction that all share equations have the same autoregressive parameter. Based on the estimates of autoregressive coefficients, a Prais- Winston procedure is applied to dependent and all independent variables. Then, we jointly estimated the cost function and the two factor-cost-share equations subject to the relevant 15

16 cross-equation constraints by using Zellner s seemingly unrelated regression method. From the parameter estimates of the cost function, the estimates of returns-to-scale and cost complementarities can be easily computed Estimation Results Table 9 shows some important parameter estimates in the cost functions. In Table 9, models (1) and (2) exclude the two firm-specific characteristics, i.e. lnal and lnbs, while models (3) and (4) include both of them. Similarly to the TFP regressions, most parameter estimates seem fairly reasonable and statistically significant. In particular, all first-order terms are highly significant. As expected a priori, the coefficients of outputs and input prices are positive, while those of e technology variable have a negative sign. The parameter estimates of lnal indicate that total costs increase with average cable length. On the other hand, the coefficients of lnbs have a positive sign, which contradicts with common sense at the first glance. This may happen because of a negative correlation between lnal and lnbs. 14 Otherwise more business operation might cause higher costs because business users tend to require more qualified and enhanced services. The coefficients of competition and regulatory scheme have a negative sign and are mostly significant, which implies that the presence of more competitors and incentive regulation leads to cost reduction. Considering that the effects of incentive regulation on TFP growth are not clear in the previous analysis, this finding suggests that the introduction of incentive regulation mainly contributes to cost efficiency rather than to revenue increase. 13 For a detailed explanation on how to calculate the estimates of returns-to-scale and cost complementarities from the parameter estimates of the cost function, refer to Gort and Sung (1999). 14 As a matter of fact, the coefficient of lnbs frequently became statistically insignificant, depending on the choice of data and empirical specification. 16

17 Finally, the coefficient of a merger variable, whatever variable is used, has a positive sign and also are mostly significant, which means that mergers may even increase total costs. In sum, it appears that mergers did not play a role of catalyst for cost cutting or restructuring in the U.S. local telecommunications industry. Table 10 shows the estimates of economies of scale and scope, which were calculated from the cost model (4). Table 10 indicates that there is no significant change in returns to scale (economies of scale) between merged and non-merged companies and also, between pre- and post-merger period. While the estimates of cost complementarities (local economies of scope) tend to decline over time in all groups, there is no systematic difference in cost complementarities between merged and non-merged companies. Clearly, merged operating companies did not exhibit stronger economies of scale and scope than non-merged companies for the pre-merger period and also, did not exhaust economies of scale and scope after mergers. Moreover, small independent companies exhibit stronger economies of scope than Baby Bells for the whole sample period. This suggests that benefits from economies of scale and scope may be exaggerated in the U.S. telecommunications merger cases Reasons for Post-Merger Under-performance Then, the natural question is why mergers did not lead to better performance for the postmerger period in the U.S. local telecommunications industry. Table 11 presents some clues regarding the question. Table 11 shows that merged companies and Baby Bells have higher capital quality than non-merged companies and independent companies, respectively, in all sample years. The capital quality for the former groups, however, did not improve as fast as that for the latter groups. Second, the average labor costs, computed by the ratio of constant labor expenses to aggregate output, are lower for merged companies and Baby Bells than for 17

18 non-merged companies and independents in the early 1990s, but the reverse is true in the late 1990s. To sum up, the monitoring costs of merged companies increased faster than nonmerging companies and also, the capital quality of merged companies did not improve as fast as non-merged companies. Obviously, mergers have a bearing on increase in the monitoring costs and delay in the capital quality improvements. 5. Conclusions The analysis provides several interesting findings. First, merged holding companies outperformed non-merged holding companies in terms of shareholder s return at least in a short period but this small gain disappeared soon. Second, there is no significant increase in TFP for merged companies before and after mergers and also, no systematic difference in TFP between merged and non-merged companies. Third, the TFP regressions show that mergers might have a negative or no impact on TFP. Fourth, in the cost analysis, we found that mergers might even increase total costs. In a word, mergers did not have any remarkable positive effect on productivity growth and cost reduction of local operating companies. Many factors, including demand fluctuations, the state of technology and policy variables, are taken into consideration in both productivity and cost analysis. Base on the finding that there is no significant change in economies of scale between merged and non-merged companies and also, between pre- and post-merger period, it seems that mergers of large Baby Bells are unlikely to produce savings from economies of scale and scope. If there are efficiencies leading to cost savings, they may result from the effect of the mergers as catalysts in bringing about cost reductions that, in principle, could have been achieved without merger. In order words, the merger event itself may have woken up management to the need for improvement or may be used as an excuse to implement 18

19 substantial unpleasant restructuring (Berger, Demsetz and Strahan, 1999). The productivity and cost analyses, however, indicate that mergers did not play even a role of catalyst for cost cutting or restructuring. In sum, mergers between big Baby Bells prove to be welfarereducing. 15 Recently, antitrust agencies in many developed countries, including the U.S., have adopted a more lenient approach to mergers between competitors. One of the main reasons is the presence of global competition, which is not always true in telecommunications sector. As a matter of fact, there may be few gains from mergers attributable to scale and scope economies in local telecommunications industry partly because local operating companies have been a monopoly in their own territories and partly because of exhaustion of these economies. Therefore, much more thought and care needs to be devoted to considering the benefits and costs of horizontal mergers, especially in local telecommunications markets. Reference Abel, Jaison R., and Clements, Michael E., A Time Series and Cross-Sectional Classification of State Regulatory Policy Adopted For Local Exchange Carriers, The National Regulatory Research Institute, Ai, Chunrong, and Sappington, David E. M., The Impact of State Incentive Regulation on the U.S. Telecommunications Industry, Journal of Regulatory Economics, 22(2), 2002, Gugler et al. (2003) argue that a majority of the mergers taking place around the world over the last 15 years appear to be welfare reducing. They regard mergers that increase market power or that reduce efficiency as welfare reducing. 19

20 Andrade, Gregor, Mitchell, Mark, and Erik Stafford, New Evidence and Perspectives on Mergers, Journal of Economic Perspective, 15(2), 2001, Berger, Allen N., Demsetz, Rebecca S., and Philip E. Strahan, The Consolidation of the Financial Services Industry: Causes, Consequences, and Implications for the Future, Journal of Banking and Finance, 23, 1999, Caves, Douglas W., Christensen, Laurits R., and Diewert, W. Erwin, Multilateral Comparisons of Output, Inputs, and Productivity Using Superlative Index Numbers, Economic Journal, March 1982, Fraumeni, Barbara M., The Measurement of Depreciation in the U.S. National Income and Product Accounts, Survey of Current Business, Jul Federal Communications Commission, Local Telephone Competition: Status as of December 31, 2001, Federal Communications Commission, Local Telephone Competition: Status As of December 31, 2000, 2000a. Federal Communications Commission, Local Telephone Competition at the New Millennium, 2000b. Federal Communications Commission, Local Competition: August 1999, Ferris, Stephen P., and Kwangwoo Park, How different Is the Long-Run Performance of Mergers in the Telecommunications Industry, working paper, Gort, Michael, and Nakil Sung, Competition and Productivity Growth: The Case of the US Telephone Industry, Economic Inquiry, 1999 Oct., Gugler, Klaus, Mueller, Dennis C., Yurtoglu, B. Burcin, and Christine Zulehner, The Effects of Mergers: An International Comparison, International Journal of Industrial Organization, 21, 2003, Lys, Thomas, and Linda Vincent, An Analysis of Value Destruction in AT&T s Acquisition 20

21 of NCR, Journal of Financial Economics, 39, 1995, Sung, Nakil, and Michael Gort, Economies of Scale and Natural Monopoly in the U.S. Local Telephone Industry, Review of Economics and Statistics, Nov./2000, Trillas, Francesc, Mergers, Acquisitions and Control of Telecommunications Firms in Europe, Telecommunications Policy, 26, 2002, Appendix: Data and Variables This appendix describes the details of data construction, especially the method measuring outputs, inputs and technology variables. Output: We use the physical unit of telephone outputs. It is widely accepted that telephone services can be classified into telephone access and usage, measured by total access lines and telephone calls. All types of telephone calls (local calls, Intra-LATA toll calls, inter-lata toll calls, and inter-lata access minutes) were aggregated into the units of telephone calls, with respective revenue shares being used as weights. Then, access lines and telephone calls were aggregated into an output variable by using a multilateral index. Labor and wage rate: Labor input is proxied by the number of full and part-time employees. Current-dollar wage rate which is actual compensation per employee is divided by consumer price index (CPI) to derive constant-dollar wage rate. Materials and material prices: The producer price index (PPI) for intermediate inputs is used as a proxy for the price of material input. Material expenses, which are defined as operating expenses minus total compensations minus depreciation charges, are divided by the material price index to derive constant-dollar material costs. The constant-dollar material 21

22 costs are regarded as material inputs. Capital and user-costs: We use two types of capital stock: net stock and gross stock. Net capital stock is constructed by the commonly used perpetual inventory method. The depreciation rates for each type of plant are obtained from Fraumeni (1997). We create gross capital stock by summing yearly real gross investments and also, by applying modified Winfrey pattern as a distribution of retirements. 16 In order to construct capital stock, we first classify telephone plants in service into three items: telephone structure (land, building, cable and wire facilities etc), telephone equipment (central office switching and transmission, operator systems etc) and general support equipment (computers, furniture, motor vehicles etc). Next, yearly dollar amounts for each category are deflated by respective National Income and Product Account (NIPA) price indexes to derive real investment for a specific year. The aggregate capital stock is the weighted sum of three types of real capital stock, with capital expense shares being used as weights. The user-costs of each type of plant consist of a constant rate of return plus the depreciation rate for that class of plant. 17 Both net and gross capital stock were constructed based on the ARMIS plant data over the period Technology variable: No single measure of technology can completely represent technological advance over time and difference in the state of technology between operating companies in telecommunications industry, especially for the sample period. A time variable, which has been commonly used in the literature, ignores difference in the state of technology between companies. The use of a short-time series data in the calculation of average vintage 16 The ARMIS reports yearly accounting data on plant retired. The use of the ARMIS data, however, did not affect the main results. 17 The constant rate of return was computed by internal rate of return minus inflation rate (change rate of CPI). The internal rate of return was calculated by subtracting operating and non-operating taxes from net operating revenues and then dividing it by net plant. 22

23 may distort the rate of technical progress and difference in the level of productivity between sample companies because most operating companies have a very long history. 18 Industryspecific measures of technology, e.g. the ratio of digital to analog access lines and the ratio of fiber to copper cables, may have another drawback. Using these measures may create misleading outcomes because digital access lines and fiber cables have occupied a small portion of telephone plants in most operating companies throughout 1990 s. The choice of a technology variable in the paper is fitted average vintage, which is obtained from regressing average vintage on time and industry-specific measures Both Gort and Sung (1999) and Sung and Gort (2000) use average vintage as a technology variable in the cost study. The use of average vintage in these studies does not cause serious problem because their company data has a long time series. It is often difficult to obtain an exact measure of average vintage for old established companies without sufficient data on gross investments,. 19 On the other hand, when alternative technology variables were used, there was no major change in the key results. The use of a time variable in the cost function produced unreliable results. This may happen because a time variable does not consider inter-firm difference in the state of technology but the sample data is wide and short. When average vintage and industry-specific measures are used in the TFP regressions, one or two coefficients became statistically insignificant. But they still have a correct sign. The use of average vintage and industry-specific measures in the cost analyses led to fairly similar results to the previous ones. 23

24 <Table 1> Major Mergers in the U.S. Local Telecommunications Markets Acquirer Firm Target Firm Completion Date Market Value ($million) SBC Pacific Telesis 1997/04/01 53,365 Bell Atlantic Nynex 1997/08/14 56,156 SBC SNET 1998/10/26 90,648 Global Crossing Frontier 1999/09/28 n.a. SBC Ameritech 1999/10/08 173,692 Broadwing Cincinnati Bell IXC 1999/11/09 3,790 Bell Atlantic GTE 2000/06/30 118,669 Qwest US West 2000/06/30 77,955 Citizens Global Crossing s local operation 2001/06/30 3,142 [Note] Broadwing is a new name for the combined firm of Cincinnati Bell and IXC Communications. The market values of a combined company are computed at the first trade day of the company stock. <Table 2> Major Events Related To First Baby Bell Mergers Date Events 1996/04/01 SBC-Pacific Telesis merger announced 1996/04/22 Bell Atlantic-Nynex merger announced 1997/04/01 SBC-Pacific Telesis merger consummated 1997/04/14 SBC-Pacific Telesis merger approved 1997/05/30 The share of SBC-Pacific Telesis combined firm began to be traded. 1997/08/14 Bell Atlantic-Nynex merger consummated and approved 1997/08/29 The share of Bell Atlantic-Nynex combined firm began to be traded. [Note] All information was obtained from each company s reports to the U.S. Securities and Exchange Commission. 24

25 <Table 3> Average Capital Gains for Local Holding Companies: Short-Term Performance (Unit: %) 96/4/1 96/4/22 96/8/1 96/12/1 97/4/14 97/8/14 GTE Citizens Utilities Frontier Sprint Alltel Cincinnati Bell SNET Independent Firms 8.3 (1.7) 8.8 (2.9) 4.8 (-2.9) 14.7 (5.9) 9.1 (6.7) 13.5 (9.1) Ameritech BellSouth US West Non-Merged Baby Bells Bell Atlantic Nynex SBC Pacific Telesis Merged Baby Bells Acquiring Firms Target Firms BA+Nynex SBC+PT [Note] Refer to the text for the calculation of capital gain or return per share. The shady cells indicate that the return per share for target companies shareholder after a merger is calculated. The averages for three groups (independents, non-merged Bells, and merged Bells) are an arithmetic mean of returns per share for respective companies, with excluding the returns per share for target companies after a merger. BA+Nynex and SBC+PT refer to the average of returns per share for the two merged firms before a merger and to the return to share for a combined firm after the merger. All calculations are carried out by using the CRSP data. The numbers in parentheses are the average of returns per share for independent companies, with excluding those for Frontier and Cincinnati Bell. 25

26 <Table 4> Average Capital Gains for Local Holding Companies: Long-Term Performance (Unit: %) 96/12/1 97/12/1 98/12/1 99/12/1 00/12/1 01/12/1 01/12/1 GTE Citizens Utilities Frontier Sprint Alltel Cincinnati Bell SNET Independent Firms Ameritech BellSouth US West Non-Merged Baby Bells Bell Atlantic Nynex SBC Pacific Telesis Merged Baby Bells Acquiring Firms Target Firms [Note] Refer to the text for the calculation of capital gain or return per share. The shady cells indicate that the return per share for target companies shareholder after a merger is calculated. The averages for three groups (independents, non-merged Bells, and merged Bells) are an arithmetic mean of returns per share for respective companies, with excluding the returns per share for target companies after a merger. All calculations are carried out by using the CRSP data. 26

27 <Table 5> Sample Operating Companies Holding Company Operating Company SBC Southwestern Bell Pacific Telesis Pacific Bell Nevada Bell BA-Washington, BA-Maryland Merged RBOC BA-Virginia, BA-West Virginia Companies Bell Atlantic BA-Delaware, BA-Pennsylvania (13) BA-New Jersey Nynex New York Telephone New England Telephone Independents SNET Southern New England Tel. Co. Bell South Bell South US West US West RBOC Ameritech Illinois Bell, Indiana Bell Michigan Bell, Ohio Bell Wisconsin Bell GTE California, GTE-Florida Hawaiian Telephone, GTE-North Non- GTE GTE-Northwest, GTE-South Merged GTE-Southwest Companies Sprint-Florida, UT-Ohio (25) Carolina Telephone & Telegraph Independents Sprint UT-Indiana, UT-Pennsylvania UT-Missouri, UT-Southeast Cincinnati Bell Cincinnati Bell Frontier Rochester Telephone Corp Central Telephone Central Telephone Co. of Virginia Others Puerto Rico Telephone [Note] RBOC and independents refer to regional Bell operating companies and independent companies, respectively. 27

28 <Table 6> Average Annual Growth Rate of Total Factor Productivity (1) TFP change based on gross capital stock (unit: %) Merged Non-merged RBOC Independents All [Note] Merged and non-merged imply merged and non-merged companies, respectively. RBOC and independents refer to regional Bell operating companies and independent companies, respectively. The shady cells indicate the TFP growth for the post-merger period. (2) TFP change based on net capital stock (unit: %) Merged Non-merged RBOC Independents All [Note] Merged and non-merged imply merged and non-merged companies, respectively. RBOC and independents refer to regional Bell operating companies and independent ompanies, respectively. The shady cells indicate the TFP growth for the post-merger period. 28