Crunch time looms for ITV merger

Next week, Patricia Hewitt, Secretary of State for Trade and Industry, will give her verdict on the merger of Carlton and Granada, the two main ITV companies. The decision, which is likely to follow the advice of the still confidential Competition Commission report on the deal now before her, will shape the media landscape in this country for many years to come. Here we consider the different scenarios that could emerge and the likely outcome.

What are the options the regulators will choose from?

Regulators could simply block the deal or wave it through. Investors, though, have focused on the middle ground between these extremes (though lawyers consider an outright ban pretty likely). Regulators have flagged up at least half a dozen possible remedies that could address the dominant market position of a merged Carlton-Granada, which would account for over half the TV advertising market in this country. Two of these solutions have emerged as the front-runners: the divestment of the both the sales houses of the combined business (a structural solution) or a "roll-over" arrangement (a behavioural solution), which would see the current advertising contracts extended for a number of years on the same terms - so there would be no price inflation.

There could be variants on these remedies or a combination of them - say, the divestment of one sales house together with some sort of behavioural undertakings.

Why do Carlton and Granada prefer a behavioural solution?

Advertising is the main source of revenue for ITV. Carton and Granada each currently have in-house sales operations, giving them control over their revenues. Sales can co-ordinate with programme making and scheduling to try to appeal to advertisers with output and sell the ITV content proposition to advertisers in a coherent way.

Having the sales houses of both companies independent would rob the combined company of control over its principle source of income and co-ordination between programming and sales would suffer.

Also financially, keeping the sales houses and merging them would mean cost savings of £20m, on top of the £35m synergy benefits of combining the rest of the businesses, according to the companies. Even though a behavioural remedy is not entirely benign for the combined ITV, it would be considered much the best outcome by the ITV management and investors.

Is a solution that would see the sales houses divested workable?

The merger is all about bringing the two companies together as a unified entity. Both companies have said that divesting the sales houses would undermine the logic of the deal and may even make the resulting business "more dysfunction, not less".

Many in the City believe shareholders want the merger so much and management is so committed to it, that the companies would have to accept whatever terms regulators impose.

There are actually different ways of separating the sales houses and the key to whether this solution will be a deal-breaker seems to be the incentive mechanism allowed.

If the independent sales houses were incentivised to maximise share of total TV advertising, that would make them work together with each other and the ITV network centre to the benefit of ITV as a whole. It is thought that Carlton and Granada could live with this.

However, it seems regulators are much more drawn to another arrangement which would see the sales houses incentivised to maximise share of all television revenues, which would make the independent ITV sales houses compete against each other. This would be good for creating competition in the market place but would be regarded as extremely destructive by Carlton and Granada and would be a possible deal-breaker (for Granada in particular).

If a form of double divestment was pursued, Granada may press for the terms of the original merger to be re-negotiated in its favour, as the loss of a sales house is a much bigger blow for Carlton than Granada, which is less highly geared and is much less dependent on ad revenues.

What are the objections of the advertisers?

Although financially, BSkyB and the BBC are much stronger than ITV and are generally seen as the "two 800-pound gorillas" in the sector, as far as advertisers are concerned there is only one 800-pound gorilla and that is ITV. ITV is still the only commercial network capable of delivering mass audiences. Advertisers complain that they have been bullied by ITV for years. As one company, its position would be much stronger still and a single ITV may trigger a merger of the other major sales houses at Channel 4, Five and Sky, reducing choices for advertisers still further.

Which is the most likely outcome?

Views in the City are pretty evenly balanced between the leading structural and behaviour remedies being recommended, but the share prices of both companies are telling us that investors believe a merger will happen. However, ask a competition lawyer and they will tell you firstly that the structural solution is statistically much more likely to be imposed by any regulator. A behavioural remedy is a much less clean solution and needs to be policed - regulators just don't have the manpower for this.

However, lawyers will also tell you there is also a very good chance of an outright ban on the Carlton-Granada deal. They hold a very different view from equity analysts and the City and, if the lawyers are right, the City has completely misread the situation.

What merger savings are available?

Some City forecasts see higher merger savings than ITV itself, such as ABN Amro (see above), while others say £100m is possible. Interestingly, there are much greater savings available to ITV from areas outside the merger - from tax breaks (the digital dividend), the savings from not having bought football rights and a much lower cost when it renegotiates the terms of its broadcast licences.

What happens if the deal doesn't go through?

The risks for Carlton would be much greater, given its high gearing and the premium rating accorded to its shares. Carlton's Michael Green is much more vulnerable and his company's shares are likely to fall much further if there's no deal.

However, since the autumn of last year, Carlton and Granada have shown they can work together in ITV and make real progress: relationships have improved with advertisers, audiences for programmes have stabilised and the ITV Digital debacle is now well behind it. The companies offer plenty of upside, even without the merger, including an advertising recovery that should begin to kick in next year.