D. THE RATE OF GROWTH OF PROFITS

EXPECTED BY CABLE OWNERS

Since any calculation of future profitability of cable systems depends crucially upon the magnitude of future price-cost conditions, estimates based upon current perceptions of these data are most precarious. Without a sound estimate of the price-cost margin in future years, it is unlikely that one will be able to predict the prospective rates of return for cable systems operating in different environments.

In this section, we present the strongest possible predictors of future price-cost margins--the estimates revealed by system owners themselves in their purchases and sales of extant systems. In the past two years, a number of acquisitions--large and small--have taken place, and the prices at which these systems sell reflect the discounted present value of all anticipated future profits.

As Mitchell has posited, cable system owners should receive a 15 percent return on investment before corporate income taxes to cover their costs of capital. Thus, the present value (PV) of any new system is equal to net revenues over all future time discounted at a rate of 15 percent. This observation may be written:

where PV/S is present value (or price paid) per subscriber, Ro is current revenues per subscriber, OC is current operating costs per subscriber, and K() is the periodic recapitalization of plant required every generation. Net revenues, R-OC, are allowed to grow at a rate g, the rate of discount is denoted r, and the length of a generation is 15 years.

If we assume that the plant must be rebuilt every 15 years, we may translate this requirement into an annual capital charge. The present value of outlays required to rebuild the system every fifteen years for a system which is one-half generation old is equal to the re-37.5r placement cost of assets times e At

22

-7.5r

-22.5r

+ e

+ e

+

a 15 percent interest rate and reproduction costs of assets of $180 to $200 per subscriber, the annual capital charge required for this typical plant is in the range of $9.80 to $11. 10 per subscriber. We utilize a figure of $10.50 in the calculations below. We may now calculate the annual rate of growth (g) in net revenues by rewriting the present value formula as:

We know that current revenues per subscriber are equal to approximately $67.92 while operating costs for median size systems are approximately $32, according to Comanor-Mitchell data. Thus, the rate of growth in net revenues per subscriber is easily found to be:

If we have information on the price per subscriber paid by firms acquiring cable systems, we can calculate the rate of growth which they are anticipating.

In order to obtain an estimate of price paid per subscriber, we have collected information on all sales of systems for which we could find complete data in the financial press in 1971 and 1972. A total of 17

22.

Don Andersson, The CATV Industry, et al., loc. cit., estimates current investment per home passed at $112. If penetration at maturity is equal to.0.65, capital costs per subscriber are equal to $172. If penetration fails to rise above its current level of 55 percent, capital costs per subscriber will be $204.

such sales were found, ranging from one system selling at $840,000 to 46 systems selling for a total price of $88.5 million. The 17-transaction sample has a reported 625,000 in current subscribers.

The data on current subscriber levels for all systems purchased were converted to "mature" subscription levels by dividing reported subscribers by a maturation factor developed by Comanor-450/t where t is system age in months. This provided

Mitchell, e an estimate of slightly more than 762, 000 subscribers at maturity. Total purchase prices for the 17 companies aggregated $350 million in stock, cash, and liabilities assumed, or $460 per mature subscriber. However, there was considerable variance about this mean figure, reflecting obviously different investment situations--differences in municipal regulation, local costs, subscription prices, and future growth potential. It might be that some systems carry franchise rights with them which are quite valuable, allowing the system owner to wire new areas at large prospective future profits. Assume, for instance, that a further 100 percent growth in homes passed is envisioned in the typical sale--certainly a very generous estimate. The profitability of these incremental subscribers is much less than that for current subscribers who reside before plant already built. If 55.3 percent of the new homes passed are enlisted as subscribers, the system will be faced with investing in new cable plant at a current cost of approximately $150 23 per subscriber." This adds $25. 17 to the annual $32 in operating costs, leaving only $10. 73 per year in excess monopoly profits (above the 15 percent rate of return required by investors). Thus, assuming each sale involves the prospect of attracting 0.553 subscribers for each mature subscriber currently passed by the existing plant, we should attribute $5.93/($33.27 + 5.93) or 15 percent of each dollar of purchase price to growth possibilities. This reduces our estimate of purchase price per mature subscriber to $391.

23Since Comanor-Mitchell estimate distribution costs to be more than 70 percent of all investment, $150 of the current $203 capitalization per subscriber is required to wire new homes.

We are now in a position to calculate the annual rate of growth of net revenues per subscriber which is being capitalized into franchise purchases by recent buyers. Referring back to (D. 3) we may easily solve for g:

Thus, current buyers and sellers of systems comprising more than 10 percent of the current industry--and including firms such as Teleprompter, Viacom, and Cox Cable--are paying prices which are consistent with

an expected 8.5 percent annual rate of growth of cash flow per subscriber. If operating costs were not to grow at all in the future, revenues would have to grow by 8.5 percent in order to justify their well-informed expectations.

The above estimate of the rate of growth expected by cable owners themselves is a minimum estimate given our conservative assumptions that:

Operating costs are but $32.00 per subscriber--a datum consistent with a system size of 15,000 to 20, 000 subscribers according to accounting statements and Comanor-Mitchell data.

All systems purchased achieve maturity instantly.

Each system has franchise rights which will yield another 0.55 subscribers for each subscriber attached to the current plant at maturity.

Since the average system sold was smaller than 15, 000, operating costs may be higher and current net revenues smaller than that calculated in D. 3. Moreover, any protracted adjustment to mature penetration levels reduces the base from which net revenues per system must grow and, therefore, increases the net growth required to justify the price paid

for the system. Finally, our assumption of one additional subscriber in areas yet to be wired for every mature subscriber before extant plant is a maximum estimate given the franchises acquired. The total number of homes in franchised areas not yet wired by the firms acquired in these 17 transactions is estimated to be approximately 700, 000 from 1970 Census of Population counts. Even if all of these homes are wired eventually, they will not equal total homes subscribing at maturity in currently wired areas. Moreover, our calculation requires that these homes be wired instantly--otherwise, the required rate of growth to justify the system purchase price must be higher.

Unless cable owners are willing to accept a lower rate of return than 15 percent on capital before income taxes, we must conclude that their actions reveal that they are expecting perpetual growth of net revenues per subscriber in excess of 8.5 percent with no increases in cost. This increase is likely to be realized in the form of new services which add to both costs and revenues, but we cannot on the basis of current evidence estimate the precise magnitude of each during future years.

This 8.5 percent growth rate for net revenues is approximately consistent with a rate of growth of gross revenues of 3 to 4 percent per annum with no cost escalation. Given the built-in wage escalators in our operating-cost formulation, we shall take 4 percent as the maximum growth rate of total revenue per subscriber, but we present estimates for a more modest growth rate of 2 percent as well.