Vertical, Horizontal Integration Change the Face of Television.

Soaring production costs, the softening advertising market and the need to find more revenue streams across multi-platforms to fund the network and studio businesses, are the driving forces behind the ever-increasing vertical integration of TV companies.

Similarly, the expanded domestic and international reach is fueling the equally notable but less high-profile horizontal integration of entertainment companies. But whether these consolidations will ultimately strengthen or undermine the global TV industry as a whole remains to be seen.

Indicative of this new economy is the vertical integration reflected by the AOL/Time Warner merger, a behemoth media entity that in the U.S. includes 54 percent of Internet access, the second largest cable system, 33 magazines with 120 million readers, 18 percent of film box office, the WB television network, the basic cable channels CNN, TBS, TNT, pay services HBO and Cinemax, 16 percent of the music market, TV production and $1.1 billion in book publishing.

In Europe last year, the German-Luxembourg CLT-UFA group, which controlled 22 TV channels reaching more than 120 million viewers and 18 radio stations in nine countries, merged with Pearson Television. Similarly, the Spanish phone company Telefonica made a $5.5 billion purchase of Endemol in Holland.

In the U.S., the recent acquisition of the Fox Family cable channel, the Saban library and Fox Kids International by Walt Disney is another textbook example of utilizing horizontal and vertical integration. Domestically, Fox Family Channel gives Disney 81 million cable homes, but the real cornerstone of the deal was Fox Kids International, which chairman Michael Eisner noted, "is a tremendous opportunity for us." Disney has already branded broadcast blocks and 14 Disney Channel premium services around the world. "We have 600 million people watching those assets a month, but now if you add in the basic advertiser-supported channels of Fox Kids," which reach 35 million people worldwide -- 25 million in Europe and 10 million in Latin America -- "you can see the dual ability between broadcast cable and premium cable that this gives the company."

Robert Iger, Disney's president, articulated the company's long-term integration strategy. "A couple of years ago we merged the Disney television production studio, Touchstone, into the ABC Television Network with the goal to substantially increase the amount of programming we owned on our network."

Ownership is becoming more and more critical to networks, in large part because of the antagonistic relationship they have with the studios that supply the programs. Bidding wars are becoming common for mid-level programs and even debuting shows are commanding top dollar. Last year, Fox paid a $1.1 million licensing fee per episode for The Street, which tanked after a few months. The networks fought back by negotiating longer licensing deals and the option to run shows more often, but they continue to lose money on their biggest hits as well as the failures.

Just as important for the bottom line is the ability to provide full infrastructure support. "Currently, Fox Family is basically a stand-alone network," Iger observed. But by integrating the channel with ABC Cable Networks and Disney Channel Worldwide, "we'll be able to provide this channel with marketing, distribution, program development, program scheduling and sales."

The horizontal integration of Fox Family and Fox Kids into the existing Disney cable channels will also add much needed cash flow. Thomas Stagg, CFO of the Walt Disney Company, explained why the deal was worth $3 billion in cash and the assumption of $2.3 billion in debt even though, on a combined basis, the acquired channels generated only $150 million of operating cash flow last year.

"That number really isn't indicative of the underlying value of the business. We think once integrated, Fox Family, which generates 75 percent of that cash flow, can drive tremendous growth in the top line, as much as a 50-percent increase in advertising revenues over the first couple of years." Stagg also predicted cost savings through integration amounting to $50 million. Sragg believes that "the Saban library, which generates the remaining 25 percent of the cash flow, has an upside potential, especially as we think of leveraging it through our worldwide television sales operation and through other outlets like home video."

"So when you put all those things together, we think that you'll be looking at doubling the current $150 million cash flow. If you look at it on that basis, you have a multiple that is less than 18 times the overall purchase. Any dilution caused by the transaction due to the debt we're taking on, we expect to earn in the first three years -- and that would be modest," Stagg related.

However, not all ramifications of integration travel so smoothly, and as of late, domestic network-news divisions seem to be feeling the heat. The economics of news divisions are deteriorating with declining ratings -- the "Big Three" evening newscasts are down 23 percent over the past 10 years -- while costs remain high. And because of the recent soft ad market, the networks, under advertiser pressure, are struggling to reach a younger demographic -- and since the news audience is traditionally older, news divisions are worried.

With the economy experiencing an overall downturn, networks are feeling the pinch so they are more reticent to keep funneling money to news. For this reason, both CBS News and ABC News have discussed a possible operational merger with CNN.

Jamie Kellner, Turner Broadcasting System's new chairman, made it clear that CNN is not looking for any new partners. "There's not going to be a merger of news operations," he pronounced. However, Kellner acknowledged there have been some discussions from the networks about finding ways to combine resources and reduce costs. To that end, he said, "There is the potential that we could do some news gathering for another network and provide some services, as we do for over 600 television stations across America today. But it would be totally separate from CNN." Kellner also sounded a warning bell about the danger of the industry becoming too vertically integrated, resulting in studios making decisions based solely on synergy. "I think it does have long-term ramifications. I think that we are going to see the industry continue to polarize toward a vertical structure, which is not good for the industry. I think it's much better if we can create new business models that allow networks to acquire programs from other suppliers. That will prevent programs from jumping from one network back to the studio-supported network."

One of the more obvious downsides to vertical integration occurred in May when ABC moved the news magazine 20/20 our of its perennial Friday 10:00 p.m. time slot and replaced it with the low-rated but Touchstone-produced series Once and Again. ABC president Alex Wallau claimed the decision was made because ABC believed it was important to air a family drama. But, other sources pointed out that it was more important for Touchstone's bottom line that the series stay on their air.

Although there is some concern over just how consolidated the entertainment industry will become, government legislation now prevents the most extreme result of horizontal integration -- the creation of a monopoly. There are also restrictions on vertical integration insofar as maintaining competition. But for those companies that haven't yet established themselves among the mega- vertically integrated players, the options appear to be running out. NBC, for example, is coming under increasing pressure to expand its position in order to remain globally competitive.

Andrew Lack, president of NBC denied speculation that NBC might opt for cable-TV distribution, particularly if frosty relations with affiliates get any icier: "We are not in any discussions about dumping affiliates and going to a cable model."

As far as changing the business model currently used by NBC, Lack pointed to PAX. "My hope is that we will find a path through PAX to gain a greater position and ultimately be able to use that channel to further the network's strength."

Moreover, Lack said, "There are cost issues out here. The above-the-line costs are increasingly difficult to manage. We're looking at issues in the way we partner with studios outside, the way we use our schedule to work with this community to get programs on the schedule that we can afford. And they make money on it and we make money on it. "He also acknowledged that increasing NBC's ownership of PAX to over 50 percent was still far off. "There are some regulations that have got to be managed, and station-cap issues. But I think we'll get there eventually."