Investing in Regulated Businesses

And British Sky Broadcasting

The visible hand of the regulator, image courtesy Wikipedia

The water and energy regulators discussed in the last two articles take a logical, generally long-term approach, to controlling their respective industries. The Office of Communications (Ofcom) lives in a very different world. Ofcom regulates the TV and radio sectors, fixed line telecoms, mobiles, postal services, plus the airwaves over which wireless devices operate. With 735 employees and a budget of 120 million pounds paid for by the industries it controls, Ofcom has the resources to get into every corner of each of its markets. Consider four recent pronouncements from its website:

1. 11 July 2013 - Ofcom announces new prices for landline and broadband prices. Prices are to fall by between Consumer Price Index (CPI) - 0 to CPI - 12% per annum.

2. 3 July 2013 - Ofcom announces that switching fees between broadband suppliers will fall from 50 pounds to 10-15 pounds.

3. 13 June 2013 - Ofcom decrees that there must be a post box within 1/2 mile of at least 98% of all 'delivery points', understood as being letterboxes of addresses.

4. 17 May 2013 - Ofcom announces that, in addition to monitoring the number of subtitles on TV, it will begin producing subtitle quality reports every 6 months.

No economic justification is given for any of these diktats.

Other recent announcements by Ofcom include research into nuisance calls, the award of the re-advertised FM local radio licence for Warminster, research into online password security risks, and a request to the UK’s advertising regulators to review the rules that limit children from being exposed to alcohol advertising on TV. After 50 rounds of bidding (yes fifty) for the 4G mobile auction, Ofcom names the four winners. They paid 2.3 billion pounds that will be recouped by these firms via higher charges from their customers. Large firms caught up in Ofcom's web include BT, Vodafone, ITV, BSkyB, and the Royal Mail.

Ofcom promotes competition by forcing companies in monopoly businesses to let other providers access to their markets via wholesale pricing.

1. BT was forced by Ofcom to create Openreach, which gives competitors access to its fibre optic super-broadband network. This is costing BT 2.5 billion pounds and it is a national objective for both the past and present governments. Ofcom controls both retail and wholesale broadband pricing.

2. Ofcom is arbitrating a complaint by BT that BSkyB is not giving it fair access to its Sky Sports 1 and 2 channels. The outcome of this dispute will have long-term repercussions on the business of both companies, though BSkyB can only be the real loser.

Unlike Ofwat and Ofgem, Ofcom has generally discarded the use of financial returns of the businesses under its control. While this disinterest in return on investment gives greater leeway to these companies, it also allows Ofcom to take decisions, which could prejudice the company concerned.

Any investor considering the purchase of shares in any company subject to Ofcom would be wise to:

1. Review recent Ofcom research papers and decisions. These are available from Ofcom's website.

2. Imagine how Ofcom might regulate new activities. Regulators become more controlling as they age.

3. Prior to the initial public offering by Royal Mail, Ofcom is already working out how it should be controlled.

4. Listen to the concerns voiced by politicians. Ofcom, like other regulators, has a sensitive ear to its political bosses.

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British Sky Broadcasting (BSkyB)

British and Irish Lions Vs All Blacks, courtesy Wikipedia

BSkyB has built up a 13-billion pound business from providing TV coverage of sports that previously cost the viewer nothing. The company has 10.8 million household subscribers that provide 82% of its revenue. This is a classic subscription business. The company has spent large sums to set a new market in sports and to build up a subscriber base by offering a unique service - TV sports and entertainment channels not available on Free TV. BSkyB cross-sells other services, presently broadband, telephone and betting. Advertising completes the revenue stream.

Revenue sources are:

1. Subscribers to the TV and broadband service paid 5.6 billion pounds in 2012. These revenues have been growing by 10.3% per annum since 2008.

2. Wholesale revenue from third parties, competitors such as Virgin Media and BT, that paid 351 million pounds in 2012. These have been growing by 18% p.a. since 2008.

3. Advertising, 440 million pounds in 2012, which has been growing by 5.8% p.a. since 2008.

4. Installation revenues of 98 million pounds that have been declining by 22% p.a. in the last 5 years.

5. Other revenues, such as betting, that amount to 309 million pounds. This has been growing by 8.3% p.a.

BSkyB has more than twice the number of subscribers of its nearest competitor, Virgin Media (recently acquired by Liberty Global). The company has an excellent record of earnings and cash generation. Consider:

1. Earnings per share have increased by 16% p.a. in the last 4 years.

2. Net margins (profit before tax/revenues) were 18% in 2012.

3. Return on capital employed (debt + equity) is currently running at 26%.

4. 5-year operating cash flows (after deducting capital expenditure and interest payments) totalled 3.4 billion pounds, twice covering the dividend payout and leaving 1.7 billion for share buybacks, acquisitions and debt reduction.

5. BSkyB bought back 697 million pounds of shares in 2012 and it has announced a further 500 million buyback for 2013.

6. Net debt of 1.3 billion pounds in 2012 could be paid back with 1.3 years' operating cash flow.

7. The balance sheet is clean of defined benefit pension scheme liabilities.

BSkyB shares (in blue) have handsomely outperformed the FTSE All Share (in green) in the past 5 years:

 

Graph courtesy of Yahoo, click to enlarge 

BSkyB's shares, currently at 842p, are valued on a forward price earnings ratio of 14 and a forward yield of 3.5% (the year-end is 30 June and results will be announced shortly). My valuation model values BSkyB shares at 1100p.*

*Earnings per share growth 10%, return on capital employed 26%, an average PE ratio of 17, and 12.2% discount rate based on BSkyB's cost of debt of 5.2% plus 2% for operating risk and 5% as a margin of safety, for the years 2014-18. 

Liberty Global valued Virgin Media (acquired February 2013 for 15 billion pounds) at about twice the current value of BSkyB: 

Valuation	What Liberty paid for Virgin M.	BSkyB at 842p
Price/earnings	57 times	16 times*
Price/revenues	3.7 times	2.0 times*
Price per subscriber	3,400 pounds	1,250 pounds*

*For the year ending 30 June 2012 

The low price put by the market on BSkyB shares is probably due to the Murdoch effect. The Murdochs are mistrusted in the UK and the Murdochs control 39% of the voting stock in the company. James Murdoch is a director (he stepped down from being Chairman). In June 2010, News International offered 700p for the shares in BSkyB and the Board replied that it would not sell for less than 800p. News International pulled out of negotiations at the time the phone hacking scandal by newspapers owned by News International caused a public outcry in the UK.

Other factors counsel caution:

1. BSkyB's credit rating is BBB+ (S & P). This is only three notches above junk.

2. Ofcom and BSkyB are at loggerheads about what competitors should pay for access to BSkyB's sports channels. The issue is currently with the Competition Appeal Tribunal. An adverse ruling would have an adverse effect on BSkyB's business.

3. Liberty Global's recent acquisition of Virgin Media at a fancy price must now be justified. BSkyB subscribers and BSkyB ties with the sporting world will be two of their targets. The new CEO of Liberty's Virgin Media subsidiary is a former BSkyB executive.
4. BT has spent close to 1 billion pounds to compete with BSkyB's football offering.

5. Improved technology could cause BSkyB's satellite dishes and boxes to become redundant.

 

[NOTE: the next article will appear on 7 August]