7.1 In order to set a price cap for each basket of controlled services, Oftel needs to be able to forecast BT's performance over the next control period. As in previous price control reviews, forecasts of BT's financial performance will be generated using a financial model.
7.2 The starting point of the financial modelling will be BT's financial performance in the current price control period. This chapter firstly sets out and explains BT's financial performance over the recent past, including the first two years of the current price control period.
7.3 The chapter then moves on to discuss the key issues which Oftel needs to bear in mind in building the financial model of BT and generating forecasts of BT's financial performance from it. These are:
7.4 Expanded discussions of these and other issues to do with financial modelling are included at Annex E.
7.5 As a prelude to the discussion of BT's financial performance in the current price control period, it is instructive to consider BT's historical financial performance over a longer timescale than that provided in the current format of the regulatory accounts. Table 7.1 shows BT's financial performance as given in BT's Financial Results By Service (FRBS) for financial years (FY) 1990/1 to 1993/4 inclusive. The range of services broadly mirrors those which are currently price-controlled.
Table 7.1 BT's Financial Performance By Service: 1990/1 - 1993/4
Access Inland calls(3)
1990/91 1991/92 1992/93 1993/94 1990/91 1991/92 1992/93 1993/94
£m £m £m £m £m £m £m £m
Turnover 2,157 2,382 2,489 2,635 4,467 4,241 4,116 4,079
Operating costs 2,794 3,097 3,094 3,066 1,765 1,493 1,598 1,596
Return(1) (637) (715) (605) (431) 2,702 2,748 2,518 2,483
Mean capital 5,986 6,434 6,715 7,067 4,952 5,619 5,639 5,293
employed(2)
ROCE (10.6%) (11.1%) (9.0%) (6.1%) 54.6% 48.9% 44.7% 46.9%
International calls Directory enquiry calls(4)
1990/91 1991/92 1992/93 1993/94 1990/91 1991/92 1992/93 1993/94
£m £m £m £m £m £m £m £m
Turnover 1,721 1,588 1,631 1,701 n/a 179 166 163
Operating costs 944 908 996 1,124 n/a 204 176 170
Return 777 680 635 577 n/a (25) (10) (7)
Mean capital 1,067 1,107 1,197 1,070 n/a 108 95 93
employed(2)
ROCE 72.8% 61.4% 53.0% 53.9% n/a (23.1%) (10.5%) (7.5%)
Private circuits TOTAL PRICE CONTROLLED(5)
1990/91 1991/92 1992/93 1993/94 1990/91 1991/92 1992/93 1993/94
£m £m £m £m £m £m £m £m
Turnover 898 975 1,018 1,025 9,243 9,365 9,420 9,603
Operating costs 733 811 891 816 6,236 6,513 6,755 6,772
Return(1) 165 164 127 209 3,007 2,852 2,665 2,831
Mean capital 1,401 1,334 1,307 1,228 13,406 14,602 14,953 14,751
employed(2)
ROCE 11.8% 12.3% 9.7% 17.0% 22.4% 19.5% 17.8% 19.2%
Source: BT's Financial Results By Service (FRBS). Not directly comparable with the more recent Financial Statements by Business and Activity.
Notes:
(1) Excludes Interest and Profit Share
(2) BT definition
(3) Inland calls do not include outgoing or incoming interconnect calls
(4) Directory enquiry calls were included in inland and international call categories prior to 1991/92
(5) Closet approximation to the services currently included in BT's PSTN and Private Circuit tariff baskets
7.6 It can be seen that the profitability of BT's price-controlled services, as measured by accounting rates of return on HCA capital employed (using BT's definition of capital employed), fell from around 22% in 1990/1 to around 19% in 1993/4. High rates of return have been earned on inland and international calls, whilst losses have been incurred on access over this period. There has been a slight trend towards convergence as BT has rebalanced its retail call and line rental tariffs to the extent to which it has been able under the RPI+2% constraint on line rentals.
7.7 Accounting data on an equivalent basis is not available for FY 1994/5. Under Accounting Separation, BT is now required, inter alia, to publish separate sets of accounts for the Access, Network and Retail Systems businesses. Table 7.2 shows the performance of each business in the two years (one year in the case of the Retail Systems business) of the existing price control period for which information is available.
Table 7.2 BT's Financial Performance By Business: 1993/4 and 1994/5 (1)
Access Account Network Account Retail
Systems
Account
1993/94 1994/95 1993/94 1994/95 1994/95
£m £m £m £m £m
Return before
ADCs:
- Total turnover 2,635 2,738 4,739 4,854 8,427
- Operating costs 3,112 3,153 3,833 3,945 6,146
- Return (477) (415) 906 909 2,281
- Mean capital 8,127 7,443 6,043 6,061 1,433
employed(2)
- ROCE (6%) (6%) 15% 15% 159%
ADC income
adjustment:
- ADCs - OLOs 55 133 Not --
relevant
- ADCs - BT Retail 1,655 1,390 (1,390)
Return after ADCs:
- Return 1,233 1,108 891
- ROCE 15% 15% 62%
Source: BT's Financial Statements for the Access, Network and Retail Business, 1994; BT's Financial Statements for the Businesses and Activities, 1995
Notes:
(1) This table must be read in conjunction with the discussion in the text.
(2) Oftel definition
7.8 Under the Accounting Separation process, BT Access and Network are allowed to earn a notional 15% rate of return on historic cost capital employed in order to calculate access deficit contributions and a standard set of non-discriminatory interconnect charges that are payable to BT Network by other operators and BT Retail. The 62% rate of return on the Retail Systems business therefore reflects the fact that all profits earned in excess of the 15% notional rate of return across all three businesses end up in the Retail Systems Account, which contains a relatively small amount of capital employed.
7.9 A breakdown of the profitability of each disaggregated activity in BT's Retail Systems Business in 1994/5 is given in Table 7.3. All of these activities except calls to mobiles, public payphones and some services within 'other retail systems business' are currently subject to price control. By omitting these three activities and adding back in the Access and Network businesses, the resulting HCA rate of return in 1994/5 for a set of businesses and activities broadly equivalent to the price-controlled services in Table 7.1 was 21%, using the Oftel definition of capital employed, and 19% using the BT definition of capital employed.
Table 7.3 Financial Performance of Retail Systems Business Activities in 1994/5 (1)
Turnover Operating Return Mean capital ROCE
costs employed(2)
£m £m £m £m
Local calls 2,081 1,708 373 145 257%
National calls 1,778 1,401 377 80 471%
International 1,673 1,336 337 841 40%
calls
Calls to 389 432 (43) (73) n.a
mobile
Directory 132 199 (67) (17) n.a.
inquiry
Public 332 319 13 168 8%
payphones
Private 1,063 1,079 (16) (188) n.a.
circuits
Other 979 1,062 (83) 478 (17%)
Total retail 8,427 7,536 891 1,433 62%
systems
business
Notes:
(1) This table must be read in conjunction with the discussion in the text
(2) Oftel definition
7.10 The current price controls were set with the aim of allowing BT to achieve normal profitability by the end of the price control period. A rate of return of 21% is higher than the 15% rate of return which Oftel has used as BT's cost of capital during the current price control period and may indicate excess profitability across the two tariff baskets. It should be noted, however, that FY 1994/5 was only the second year of the control period, and that further reductions in HCA rates of return may occur by 1997 as the price controls continue to force BT's average prices down in real terms. Moreover, as discussed at length at Annex E, there are problems with using accounting rates of return based upon historic cost asset bases as a measure of economic profitability.
7.11 An alternative and theoretically more correct way of estimating BT's profitability over the period would be to calculate the internal rate of return on a set of activities using a cashflow approach (see paras. E.53 to E.54 of Annex E). It is difficult to obtain direct estimates of the economic rate of return on BT's price-controlled activities using this approach, because of the problems with estimating the relevant economic value at the start and end of the period. Nevertheless, it is possible to estimate the rate of return of BT Group as a whole using published accounts and share price information. Using BT's market capitalisation at the start of FY 1990/1 and FY 1995/6, and estimating free cashflows in between, the post-tax economic rate of return for BT Group over that five-year period was around 16% in nominal terms.
7.12 The aim of the financial modelling is to find a price control for each tariff basket which allows BT to earn an acceptable rate of return by the end of the next control period (subject to the views received as a result of consultation on the desirability of a one-off adjustment to prices).
7.13 In a competitive market, a firm would be expected to earn a rate of return that was on average equal to its cost of capital. A firm in this situation can be described as being of normal profitability. In general, the higher the riskiness of the firm's activities, the higher its cost of capital, since investors typically require compensation for greater risk.
7.14 As referred to above, in recent price determinations and when setting BT Network's standard interconnect charges, Oftel has implicitly used a nominal pre-tax cost of capital of 15% applied to an HCA asset base. Oftel needs to consider the appropriate cost of capital to use in the modelling of price controls for each tariff basket and sub-cap over the next price control period. In the consultative document to be published in March, Oftel intends to present the range of estimates for the cost of capital that it has used in the financial modelling alongside the proposed range of values of X for each price cap and sub-cap.
7.15 A variety of methods exists for measuring the cost of capital of BT as a firm. Annex E discusses in more detail the theory of how the cost of capital can be estimated, and gives indicative estimates of BT's cost of capital under a range of different assumptions. Some of the most important assumptions which affect the cost of capital estimate are set out below, in rough order of their relative impact on the estimate obtained:
7.16 Under certain simplifying assumptions, discussed in paras. E.47 to E.49 of Annex E, Oftel's initial view is that the pre-tax weighted average cost of capital (WACC) for BT Group could lie in the range 9.2% to 13.4% in nominal terms, which is equivalent to a range of 6.1% to 8.8% in real terms. These ranges assume a 15% gearing ratio, and do not therefore take into account any possible reductions in the WACC as a result of moving to a more desirable level of gearing.
7.17 The cost of capital for BT's price-controlled activities may be somewhat lower than this, reflecting their lower risk. As an illustrative example, the lower end of the range would fall to 8.4% in nominal terms and 5.2% in real terms if BT's price-controlled activities were assumed to be of equivalent risk to that of a utility-type business. A breakdown of the components of this indicative range and a comparison with those used by the MMC in a recent report are shown in Table E.5 of Annex E.
7.18 The issue of levels of gearing in the balance sheets of regulated utilities has received media attention recently. If BT were to significantly increase its gearing beyond levels considered prudent, whatever the motivation, Oftel would not allow any resultant increase in its cost of capital to be reflected in the next or any future price control regime.
Oftel would welcome views on its proposed range for the pre-tax weighted average cost of capital for BT, the assumptions that lie behind the choice of this range (discussed at Annex E), and the size of any adjustment necessary to arrive at a cost of capital for the price-controlled activities.
7.19 BT uses the conventional HCA basis of accounting, where fixed assets are valued at original purchase cost net of cumulative depreciation. This has the merit that most of its competitors use the same method of asset valuation. In the past Oftel has regulated BT on the basis of HCA rates of return, which have been compared to a pre-tax nominal cost of capital.
7.20 However, accounting rates of return based upon historic cost asset valuations are subject to several criticisms if they are to be used as a measure of economic profitability. The main problems are that historic cost asset valuations do not measure the true economic value of the resources employed in the business, and that accounting depreciation policies used in the balance sheet and profit and loss account of the company do not in general correspond with underlying economic reality.
7.21 In modelling BT's financial performance over the next control period, therefore, Oftel intends to consider moving to a more appropriate method of calculating BT's rate of return, such as one based upon CCA accounting values and economic rates of return. Under certain restrictive assumptions, these rate of return measures have the merit of being directly comparable with the estimates of BT's cost of capital that are used in the financial modelling. They are also consistent with the forward-looking cost methodology that Oftel favours in relation to the network charge cap (see Chapter 5).
7.22 When moving from regulation on the basis of HCA rates of return to CCA or economic rates of return, there are two potential difficulties to be overcome. Firstly, it will be necessary to ensure that the revaluation of assets does not result in windfall gains or losses to shareholders. For BT's regulated business, CCA valuations of assets are approximately 10% higher than HCA valuations, based on 1993/4 data. In principle, any windfall gains or losses as a result of asset revaluation could be taken into account in the financial modelling by treating the revaluation surplus as a positive cashflow in an internal rate of return calculation. However, there may be difficulties in estimating the size of the revaluation surplus, due to the complexities of the capital value adjustment. This is discussed in the context of a network charge cap in Chapter 5. Secondly, there could be significant potential for confusion if Oftel were to set a price control based upon one measure of profitability (economic rates of return) when BT reports to its shareholders on the basis of another measure (HCA rates of return on capital employed). Oftel will need to ensure that the implications for the HCA rates of return reported in BT's accounts are fully explained, since these are the only measures of BT's financial performance available to and understood by a wider audience.
Oftel would welcome views on the most appropriate methodology for calculating the rate of return on different activities in order to compare it to estimates of the cost of capital for those activities. It would also welcome suggestions on how a change in the basis of regulation to CCA or economic rates of return could be reconciled with the HCA rates of return which BT reports to its shareholders and the wider community.
7.23 The expected future financial performance of BT will be assessed using a financial model. The model will be used to project forward BT's costs, revenues and capital employed for the services within each tariff basket.
7.24 Based upon the forecasts derived from the model, a range of values of X will be chosen for each price control so as to allow BT to earn an expected rate of return which Oftel regards as acceptable by the end of the control period (subject to views expressed in consultation on this document on the desirability of a one-off adjustment to prices at the start of the period). This in turn depends upon the view that Oftel takes upon BT's cost of capital for those services and upon the calculation of the rate of return earned on them, as discussed in the previous sections.
7.25 In the March consultative document, Oftel intends to publish the details of the range of X for each tariff basket and sub-cap that it proposes as a result of its financial modelling. At the same time, it will explain the assumptions and parameters underlying the range of price controls, as well as the forecasts of the financial performance that BT is expected to achieve in the activities within each price cap or sub-cap.
7.26 The ranges of values for X derived from the modelling process will depend crucially upon the view taken about the values of the key variables that will affect BT's financial performance over the next control period. These variables can be split into two groups: those that will affect BT's revenues (demand side) and those that will affect BT's costs.
7.27 Key determinants of BT's future performance on the demand side are likely to be the future growth of the markets in which BT currently operates (or is likely to enter) and its share of those markets. On the cost side, the key areas where Oftel invites submissions at this stage are the efficiency (productivity) improvements that BT should be able to achieve over the next control period. These key modelling assumptions are touched upon in this chapter and discussed in greater depth at Annex E.
7.28 When forming a view about the future movement in key input variables to the modelling over the forecast period, it is useful to consider how these have moved in the past.
7.29 One of the main drivers of BT's revenues and therefore financial performance, will be the growth of the markets in which BT currently operates, as well as those new markets which are likely to develop over the next control period.
7.30 Until recent years, BT supplied the majority of the retail markets for simple voice telephony and private circuits, which are discussed in some detail in Chapter 3 and Annex C. Table 7.4 shows annual growth rates in the simple voice telephony service markets supplied by BT's retail operations over the period since privatisation. Demand for exchange line access, inland and international calls, as approximated by that proportion of the market supplied by BT, has expanded rapidly in the last ten years, driven by a combination of falling real prices (as a result of price cap regulation and increasing competition), rising real incomes and technological innovation.
Table 7.4 Growth In Volumes of Simple Voice Telephony Services Supplied By BT: 1984/5 - 1994/5
1984/8 1985/8 1986/ 1987/8 1988/8 1989/9 1990/ 1991/9 1992/9 1993/9 1994/
5 6 87 8 9 0 91 2 3 4 95
% per annum
Number of exchange
lines at end-year:
- business 4 5 5 8 11 10 4 1 2 3 5
- residential 3 3 3 3 3 3 2 1 2 2 1
- total 4 4 3 4 5 5 2 1 2 2 2
Call minutes during
year:
- inland calls 8 7 7 8 11 10 4 1 0 6 7
- international* 14 11 11 14 13 13 6 4 6 6 5
Source: BT Annual Report & Accounts
Note: *International call volumes include outgoing, incoming and transit calls
7.31 Market data on simple voice telephony volumes supplied by all operators has been collected by Oftel over the last three financial years, and is shown for reasons of comparison in Table 7.5. This shows that the total market demand for these basic services has increased more quickly than BT's output over this period. Unfortunately information on trends in demand for other key services, such as private circuits, is not available in a comparable form.
Table 7.5 Growth In Market Volumes of Simple Voice Telephony Services: 1992/3 - 1994/5
1992/93 - 1993/94 1993/94 -
1994/95
% per annum
Call minutes during year:
- inland calls 7 8
- outgoing international 11 13
calls
1992/93 1993/94 1994/95
Number of exchange lines at
end-year:
- business 2 4 7
- residential 2 3 3
- total 2 3 4
7.32 For the purposes of financial modelling, Oftel needs to take a view on future growth prospects for all those retail and network markets which BT currently serves. In the model, it also needs to consider the potential effect of any new telecoms products that are likely to appear over the next control period. The factors which Oftel will take into account in arriving at a decision on the prospects for market growth in the key areas are considered at greater length in paras. E.74 to E.76 of Annex E.
Oftel would welcome opinions on the likely trends in demand in the main service markets identified in Chapter 3 (both network and retail) over the next control period. It would also welcome views on the likely scale of demand for important new telecoms products that may appear over the period.
7.33 Given forecasts of overall market demand, forecasts of BT's revenues and overall financial performance will depend crucially upon the assessment that is made of what share of each market BT supplies through its network or retail arms. The details of how Oftel proposes to model BT's market shares are discussed in paras. E.77 to E.83 of Annex E.
Table 7.6 BT's Share of Simple Voice Telephony Markets: 1991/92 - 1994/95
1991/92 1992/93 1993/94 1994/95
Percentage (%)
Call minutes during
year:
- inland calls n/a 93.4 91.7 89.6
- outgoing n/a 77.4 73.5 69.3
international calls
Exchange lines at
end-year:
- business 97.2 96.4 95.9 94.8
- residential 99.2 98.8 97.7 95.7
- total 98.8 98.2 97.3 95.5
7.34 Table 7.6 shows BT's share of simple voice telephony markets over the last three years, measured by volume. This shows that market share loss has not been dramatic up to now. However, the evidence presented in Chapter 3 suggests that retail competition may emerge very rapidly in certain markets.
7.35 It is Oftel's intention to take account of responses to the questions posed in Chapter 3 and Annex C on effective competition, and their implications for BT's share of the key network and retail markets, in the modelling.
7.36 In order to project forward BT's financial performance, Oftel needs to take a view on how BT's costs will move over the next control period, both as a result of the demand-side influences discussed above and as a result of the productivity growth BT should achieve. The relationships between costs and demand and the proposed treatment of capital expenditure and common costs within the model are discussed in paras. E.84 to E.93 of Annex E. In this section, the measurement of BT's historical efficiency improvements and how Oftel intends to take account of future efficiency improvements is discussed.
7.37 The efficiency improvements expected over the next control period are a key component of the modelling exercise for the price control review, since the future controls need to be set with a view to allowing BT an acceptable rate of return after taking account of the efficiency improvements that could reasonably be expected.
7.38 The standard measure of efficiency that has been calculated for BT by Oftel in the past is an index of real unit costs, which measures the total cost incurred by BT per unit of output. Since privatisation, BT's unit costs have fallen by around 3.5% per annum on average across its combined retail and network activities. As discussed in relation to the network charge cap in Chapter 5, preliminary results from the benchmarking study commissioned by Oftel based on comparisons with overseas operators suggest that BT's efficiency across its combined network and retail activities may be up to 10% less than that of the best-performing comparable competitors.
7.39 One problem with basing assumptions about productivity gains for the next control period on those achieved historically is that the past may not be a good guide to the future. A further difficulty with forecasting BT's costs is how to treat exceptional costs and redundancy costs. If they are allowed to count towards the price control, BT may have an incentive to overstate its forecast redundancy payments. In its financial modelling, therefore, Oftel will consider the implied real unit cost reductions both excluding and including redundancy and restructuring payments.
Oftel seeks views on the efficiency improvements that could be expected of BT in its network and retail activities over the next price control period.
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