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Public Notice
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Ottawa, 14 March 1991
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Public Notice CRTC 1991-29
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Rate of Return Measures and Profitability Benchmarks for the Cable Television Industry
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In Public Notice CRTC 1990-53, dated 15 May 1990, the Commission stated that it would retain a consultant to: (i) propose and assess various methods that could be used to measure cable industry profitability, including rate of return on net fixed assets, and any alternative measures that might be appropriate; (ii) propose appropriate benchmarks for use in connection with current or proposed methods of establishing profitability levels; and (iii) assess the feasibility of establishing an appropriate profitability benchmark within a range, rather than as a single, fixed number. With respect to the third task, the consultant was to examine the basis on which a licensee's allowed return would be established within this range.
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The contract to carry out this study was subsequently awarded to Dr. Cleveland S. Patterson, Associate Professor of Finance at Concordia University, Montreal, and President of Cleveland S. Patterson and Associates Ltd., Toronto. Dr. Patterson's report, entitled "Rate of Return Measures and Profitability Benchmarks for the Cable Television Industry", was issued for public comment in Public Notice CRTC 1990-97, dated 19 October 1990. The Commission received 14 written comments on Dr. Patterson's report by the deadline of 21 December 1990 and wishes to thank all parties that participated in this proceeding.
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The Commission has carefully considered the written comments in making a final determination as to the appropriate rate of return measure and profitability benchmark to be used in assessing proposed rate increases pursuant to subsection 18(8) of the Cable Television Regulations, 1986 (the Regulations).
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The following sections set out in some detail the basis for the Commission's findings.
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Dr. Patterson's Formula
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Dr. Patterson recommended the use of the following formula to derive the after-tax profitability benchmark for the purposes of rate increase proposals filed under subsection 18(8) of the Regulations:
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Benchmark (%) = (r(5) + 4)(1 - 0.4T)
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where r(5) is the average monthly yield on long-term government bonds during the previous five calendar years, and T is the current combined federal and provincial statutory tax rate applicable to the typical firm.
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For 1990, r(5) is 10.1%. Assuming that T = 45%, the current level of the recommended benchmark would be 11.6% according to the formula. Dr. Patterson's formula is composed of two parts. The first part, (r(5) + 4), is a return level that Dr. Patterson considers would be reasonable for a cable system financed entirely by equity capital. In Dr. Patterson's words, "the competitive, technological, regulatory, and economic risks to which basic cable operations are exposed justify a return which is four percentage points higher than that available on average from investments in very low-risk government bonds".
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The second part of the formula,
(1 - 0.4T), reflects the fact that debt financing can reduce the required return because of the tax deductibility of interest payments. Dr. Patterson assumes that a prudent minimum debt level for a typical cable company is 40% of total capital.
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While parties commenting on Dr. Patterson's report were generally supportive of his approach and the use of a formula to derive the benchmark rate of return, concerns were expressed with respect to Dr. Patterson's conclusions on the specific elements in his formula. The issues raised by parties included: the appropriate risk-free rate; the derivation of the risk premium of 4%; the appropriateness of the 40% debt ratio; and, the need to adjust the benchmark to reflect the fact that a licensee's net fixed assets may be financed by sources other than debt and equity.
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There was much discussion regarding Dr. Patterson's risk premium for basic cable service over low-risk government bonds. The risk premium is composed of two elements, a market risk premium and a risk measure for basic cable service referred to as "beta". Dr. Patterson relied on a best estimate of 7% for the market risk premium and a beta of 0.6 in arriving at a risk premium of 4%.
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A number of parties criticized Dr. Patterson's conclusions with respect to both the market risk premium and the appropriate beta for basic cable service. Regarding the former, concerns were expressed with respect to a few of the studies relied on by Dr. Patterson to derive the market risk premium. With regard to the latter, there was considerable comment on the methods and assumptions used by Dr. Patterson to estimate the beta for the provision of basic cable service.
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The Commission has carefully considered Dr. Patterson's evidence and the comments of interested parties and has concluded that Dr. Patterson's findings, including those with respect to the market risk premium and the appropriate beta for basic cable service, are reasonable. Accordingly, the Commission adopts Dr. Patterson's formula as the basis for deriving a benchmark rate of return for basic cable service, subject to the modifications discussed in the following sections of this public notice.
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The Use of an After-Tax Benchmark
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Dr. Patterson defined the benchmark in after-tax terms, in order to make the benchmark more comparable to other return information available to the public, such as yields on bonds, or total returns realized on stocks and mutual funds, which are commonly quoted in after-tax terms. By contrast, the Commission's current benchmark of 24% is based on a pre-tax measure of profitability. On a pre-tax basis, the equivalent to the 1990 benchmark level of 11.6% would be 21.1%.
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The Canadian Cable Television Association (CCTA) was the only party to comment on this issue. They expressed support for stating the return on net fixed assets, as well as the benchmark, in after-tax terms on the grounds that it should allow a more meaningful comparison with returns earned by other investment alternatives.
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The Commission acknowledges the problem of comparability of return information that led to Dr. Patterson's recommendation to use an after-tax benchmark. At the same time, the Commission considers that it would be inappropriate to use an average tax rate of 45% both to derive the benchmark and to calculate an individual licensee's earned return, because some licensees are taxed at a rate other than 45%.
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The Commission is of the view that it would be necessary to use actual tax rates to calculate a licensee's after-tax rate of return and to adjust the benchmark accordingly. However, individual calculations of this nature would unduly burden the Commission and licensees, and this additional complexity would outweigh the benefits of moving to an after-tax basis. Accordingly, the Commission has decided to continue its current practice of defining the benchmark and computing earnings in pre-tax terms. Comparison of Benchmark with a Licensee's Return on Net Fixed Assets
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Dr. Patterson recommended that the rate of return measure, which should be compared with the benchmark, should be the ratio PBIT(1 - T)/NFA, where PBIT is profit before interest and taxes, NFA is average net fixed assets, and T is the same tax rate used to determine the benchmark. For the reasons discussed in the previous section, the Commission will continue to use the pre-tax rate of return on net fixed assets (PBIT/NFA) as the rate of return measure.
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Dr. Patterson also recommended that the rate of return should be averaged over seven years, with the average computed using historical returns for each of the preceding five years, together with projected returns for the current year and the following year. Projected returns should incorporate the pro forma effects of proposed increases under subsections 18(2), (3), and (6) of the Regulations. This recommendation may be contrasted with the eight-year time period currently used by the Commission, consisting of seven historic years and the current fiscal year.
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Dr. Patterson explained that the use of projected data as part of the seven-year period was intended to mitigate the problems of those licensees who have experienced declining returns in recent years and expect the decline to continue, possibly to the point of financial jeopardy and loss of credit, but whose earlier earnings are sufficiently high to maintain the long-term average above the benchmark. While recognizing that the use of a forward year in the seven-year average presents opportunities for overly conservative earnings projections, Dr. Patterson considered that the effects of underestimation of future returns are relatively minor and that the potential benefits are likely to outweigh any potential problems.
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A number of parties commented on the time period recommended by Dr. Patterson. Bell Canada (Bell) and Fundy Cable Ltd./Ltée (Fundy Cable) supported Dr. Patterson's seven-year period. The CCTA, Classic Communications Ltd. (Classicomm), Cogeco Inc. (Cogeco) and Mountain Cablevision Ltd. (Mountain Cablevision) also agreed with the concept of a seven-year period, but argued that it should be oriented more towards the future. Accordingly, they recommended the use of four historic years, the current year and two prospective years.
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The Commission considers that the seven-year period recommended by Dr. Patterson is more appropriate than the current eight-year historic period used by the Commission. The use of a seven-year period allows the Commission to assess the industry's financial results over a reasonable business cycle, while the inclusion of one prospective year allows the Commission to take the future into account in assessing current economic need.
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The Commission does not agree with the recommendation put forward by a number of parties that the seven-year period include two prospective years. Given the practical limitations of reviewing pro forma statements more than one year forward and the opportunity for overly conservative earnings projections by licensees if more than one prospective year is used (a concern raised by Dr. Patterson), the Commission will compute a licensee's earned return over seven years, consisting of the past five years, the current year and one year forward.
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The Level of the Benchmark
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Dr. Patterson recommended that rate increases should be permitted whenever the seven-year average return on net fixed assets is below the benchmark. Dr. Patterson's formula yields a pre-tax benchmark of 21.1% which he recommended for Class 1 licensees.
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For Class 2 licensees, Dr. Patterson recommended that the benchmark be set at a level one percentage point higher on an after-tax basis than that for Class 1 systems. On a pre-tax basis, the benchmark for Class 2 licensees would be 22.9%. The purpose of this recommendation was to recognize the greater business risks and limited access to capital which, in his view, characterize many smaller licensees.
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Dr. Patterson recognized that many of the risks facing small operations are a function of the financial strength of the organization within which they are embedded rather than of their own individual size. He noted, as an example, that a small undertaking owned by one of the large publicly-traded companies would have access to capital and technical resources that an independently-owned undertaking with a comparable number of subscribers would not. However, Dr. Patterson concluded that such risk differences are difficult to assess with any useful degree of precision and, therefore, he recommended for simplicity that all Class 2 licensees be considered small companies to whom the higher benchmark would apply.
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A number of parties questioned the basis on which Dr. Patterson arrived at his recommended risk premium for small systems. Further, the CCTA, Monarch Cable TV Ltd. and Fundy Cable expressed concern that Dr. Patterson did not recognize differences between small systems that are independently owned as opposed to those that are part of larger organizations.
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Turning to the magnitude of allowed rate increases, Dr. Patterson recommended that such increases be related to a range rather than to a single point. Dr. Patterson was concerned, for a number of reasons, about limiting rate increases to an amount which would raise the seven-year average to a level just equal to the benchmark. First, since the benchmark is estimated and not measured, it is subject to some degree of variation based on informed judgement. Further, in Dr. Patterson's view, economic need must take into account such factors as the level and nature of current and projected cash flows, and future financing requirements, as well as the identification of economic profits. Dr. Patterson also considered it desirable that regulatory procedures be designed to provide incentives for improved performance.
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Finally, Dr. Patterson was concerned that "if a point is used, then when average earnings slip marginally below the benchmark, increases will tend to be very small. Moreover, if there are downward pressures on earnings, they will be very frequent. The resulting series of changes every year is likely to be annoying to subscribers and also creates unnecessary uncertainty for licensees".
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Therefore, Dr. Patterson recommended that rate increases should normally be sufficient to raise the seven-year average rate of return to a level that is one percentage point above the after-tax benchmark. While Dr. Patterson recognized that a range of one percentage point is "obviously arbitrary, it is consistent in order of magnitude with the inherent uncertainty of the benchmark estimate and also with the typical range of variability of the aggregate after-tax return for the industry over time".
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The Government of Ontario (Ontario), Bell, and AGT Limited commented on this issue, arguing that rate increases should be sufficient to raise the average return over the seven-year period to a level just equal to the benchmark. Classicomm was the only other party to address this matter, suggesting that the range should be broader to ensure that the financial requirements of all licensees can be accommodated.
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The Commission notes that the effect of Dr. Patterson's recommendation is that, for 1990, Class 1 licensees with a seven-year average rate of return less than 21.1% on a pre-tax basis would be eligible to apply for a rate increase. Rates would then be set to achieve a return of 22.9% on a pre-tax basis. The Commission has concluded that it would be inappropriate to have one threshold to determine eligibility for a rate increase under subsection 18(8) and a different threshold to determine the magnitude of the allowed rate increase. In particular, the Commission considers that Dr. Patterson's recommendation would be unfair to Class 1 licensees whose seven-year average return was between the two thresholds, namely between 21.1% and 22.9% based on the 1990 benchmark recommended by Dr. Patterson. Licensees with a seven-year average return below 21.1% would be eligible for a rate increase sufficient to bring their average to 22.9%, whereas licensees with an average return between these two levels would be ineligible for a rate increase.
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The Commission therefore considers it appropriate to adopt a single threshold or benchmark to determine eligibility for and the magnitude of a rate increase under subsection 18(8). In this regard, the Commission prefers Dr. Patterson's threshold regarding the magnitude of allowed rate increases as the single benchmark for the purposes of subsection 18(8) rate increase applications.
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The Commission agrees with Dr. Patterson's view that the level of the benchmark derived from the formula is subject to variation and that economic need must take into account such factors as the level and nature of cash flows and future financing requirements. The Commission therefore concludes that rate increases should generally be sufficient to increase the seven-year average return to a level one percentage point above the after-tax benchmark derived from Dr. Patterson's formula, 1.8 percentage points above the pre-tax benchmark, and that this threshold should also determine eligibility for a rate increase.
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For the year 1990, the pre-tax benchmark would be 22.9%, which the Commission proposes to round to 23% for the purpose of administrative simplicity.
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Further, the Commission is not persuaded that a risk premium for Class 2 systems is warranted. In the Commission's view, Dr. Patterson has not adequately addressed the differences in the risks facing small systems that are owned by other companies as opposed to those that are independently owned, nor has he justified the use of the existing division of licensees into Class 1 and Class 2 systems as the basis for a small system risk premium.
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The Commission has therefore decided to adopt a single benchmark of 23% for the purposes of subsection 18(8) applications for Class 1 and Class 2 systems. The Commission recognizes that there may be some small independent systems facing substantially higher operating or financial risks than small systems owned by other companies. The Commission considers that such systems may be considered for treatment as exceptions to the general policy framework under subsection 18(8) on a case-by-case basis. The Ceiling on Subsection 18(8) Increases
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To avoid excessive one-time increases in subscriber rates, Dr. Patterson recommended that rate increases pursuant to subsection 18(8) be limited to 10% in any single year. In his report, Dr. Patterson provided some examples of situations in which comparison of the benchmark to the seven-year average return could result in very large rate increases. In his view, some constraint is necessary to prevent unreasonable increases that would likely be unacceptable to subscribers. Dr. Patterson recognized that the magnitude of the ceiling is obviously arbitrary, but argued that a limit of 10% would be reasonable.
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A number of parties supported the 10% cap proposed by Dr. Patterson, including the CCTA and Ontario. Ontario recommended that the cap be calculated in relation to the base portion of the licensee's monthly rate.
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Fundy Cable, Classicomm, Cogeco and Mountain Cablevision recommended that, where a licensee is eligible for a rate increase in excess of the 10% cap, the Commission allow for a two-stage rate increase. That portion of the rate increase in excess of the cap would be implemented in the following year. While Classicomm argued that both increases should be given final approval in year one, Fundy Cable suggested that the licensee would have to demonstrate that its return continued to fall below the benchmark before the second-year rate increase would receive final approval. Classicomm also argued that there should be no ceiling on the annual increases under subsection 18(8) or that the cap, if imposed, should be higher. Bell, on the other hand, recommended that the cap should be lowered to 5%.
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The Commission considers that the 10% ceiling proposed by Dr. Patterson is a reasonable method of ensuring that subscribers do not face excessive rate increases in a single year. Accordingly, the Commission will generally limit a rate increase pursuant to subsection 18(8) in a given year to 10% of the base portion of the basic monthly fee in effect at the time of filing the subsection 18(8) application.
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The Commission does not accept the recommendation put forward by a number of cable licensees that the amount of a requested rate increase in excess of the cap be authorized for implementation in the next year. Licensees whose rate increases in a given year are limited by the 10% ceiling may re-apply the following year if their seven-year average return on net fixed assets remains below the benchmark.
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Exceptional Circumstances
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Dr. Patterson recommended that, in exceptional circumstances, where a strong case can be made by a licensee, consideration should be given to granting rate increases under subsection 18(8) when the seven-year average return is one percentage point or less above the after-tax benchmark, or 1.8 percentage points or less above the pre-tax benchmark. In such cases, the rate increase should normally be sufficient to raise the average return to a level one percentage point above the after-tax benchmark, provided the increase does not exceed 10%.
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Dr. Patterson identified three circumstances under which a licensee might request consideration of such an increase:
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a) the average return on net fixed assets is one percentage point or less above the benchmark, but the seven-year average return on gross fixed assets is below the benchmark;
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b) the average return on net fixed assets is one percentage point or less above the benchmark but, due to operating efficiencies, the requested subscriber rate is materially below the average for other systems which are comparable in terms of service quality, size, and subscriber density; and,
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c) special conditions where plans for quality enhancement will require very large capital additions during the forecast period. Such plans may not reduce the average return on net fixed assets below the benchmark, even when projections are included, if returns have been high in past years.
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The Commission notes that the exceptions identified by Dr. Patterson deal with the situation created by having one threshold to determine eligibility for a rate increase under subsection 18(8) and a different threshold to determine the magnitude of the allowed increase. In particular, using 1990 as an example, it would allow a licensee whose seven-year average return was between 21.1% and 22.9% on a pre-tax basis to qualify for a rate increase in the above-noted circumstances.
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However, since the Commission has decided to address this problem by adopting a single threshold to determine eligibility for a rate increase and the magnitude of an allowed rate increase under subsection 18(8), there is no need to identify exceptional circumstances for licensees whose seven-year average return falls between the two thresholds.
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Revisions to the Benchmark
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Dr. Patterson's formula for arriving at a benchmark contains a number of variables, including the average monthly yield on long-term government bonds during the previous five calendar years and the risk premium for the cable industry. The Commission intends to monitor any changes in the yield on government bonds as well as economic changes affecting the cable industry on a periodic basis to determine if changes to the benchmark are required.
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Conclusion
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In summary, the Commission's general policy framework for assessing rate increase applications filed pursuant to subsection 18(8) of the Regulations is as follows: (i) the appropriate pre-tax profitability benchmark is 23%;
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(ii) the rate of return measure to be compared with the benchmark is the pre-tax rate of return on net fixed assets averaged over seven years, using historical returns for each of the preceding five years, together with projected returns for the current year and the following year;
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(iii) the magnitude of the allowed rate increase will normally be sufficient to raise the seven-year average return to a level equal to the benchmark, subject to the ceiling set out in (iv) below;
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(iv) the Commission will generally limit a rate increase pursuant to subsection 18(8) in a given year to 10% of the base portion of the basic monthly fee in effect at the time of filing the subsection 18(8) application;
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(v) these procedures apply to Class 1 and Class 2 licensees (with more than 2000 subscribers); and,
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(vi) exceptions to this general policy framework will be considered on a case-by-case basis where unusual circumstances so warrant.
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All subsection 18(8) rate increase applications filed after the date of this public notice will be assessed in accordance with the findings summarized above. Applications that have been received prior to this date will be judged according to the interim procedures outlined in Public Notice CRTC 1990-97.
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Allan J. Darling
Secretary General
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