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HomeMy WebLinkAbout1982 iR T p 1, ra • FAR 4 ~.~'~r~i.44b r'te4,tiApAM~Wriy: rv'!,i' , y,~+l V14 :nl L. t ~ r♦' cSr 'ri'.rMd9UlY Kl ?Y'MTq 4 i ",aip r,~ 'T1 A ir ♦r IV. NS .Ji 1 r rr j A ni4J 1 D, ff~~,,xw ~~-iYrFgqrrr~~ brY:' rti-w~•'r0 r~~T'~I`~j~yQy~ii~l r{', ~.(T'1~11'ay'+y4ri 4J'a~ ,L.i .tJt"~{h:;'Rik,.l4r„liic~lsl,p{.'q'kgt1E.J1l 'i?~y1'6if 1$M.~'7 ,w .''Sr Jan-q "1~j7U"'s'l MI'. 1^ r~r xfy klr~rx ri@kay ka { r n r" ~:Y ~ we~''L..~ r~~~' r~~~Q.,~ • q~ 1 tr~~..1+ 4~ 1 1 it i ~ ~ 1~~. r ~ c ; it :I ~ :'!~My'3.ra,1..,`? ~ ~ r, H s ~ J !f. r~.`.rv+r~ +~rY..r r rte' i~. r waw 1 p y .~rrfi~a '~r,Yr ~~~lrk dy T V I. 1 ♦ •7 1 py o~ Mr:c J kuetati ~ Cff:n ~ v w 1rr "Ate f t ~ ANALYSIS OF RATE INCREASE PROPOSAL MADE TO DENTON, TEXAS BY GOLDEN TRIANGLE COMMUNICATIONS Prepared By CTIC ASSOCIATES 1800 N. Kent Street Arlington, VA 22209 (703) 528-6838 ANALYSIS OF RATE INCREASE PROPOSAL ?FADE TO DENTON, TEXAS BY GOLDEN TRIANGLE COMMUNICATIONS 1. INTRODUCTION CTIC Associates has examined the rate increase proposal by Golden Triangle Communications to Denton, Texas. The report which follows examines the various financial aspects of the proposal, raises some questions which the City may seik to resolve, and presents our preliminary findings. In addition, we seek to offer the City staff a complete descriptlon of how we approach rate regulatory analysis ao that the, City might perform this type of service %n- house" in the future. We begin our analysis by outlining what we consider to be the appropriate criteria for developing an ongoing regulatory procedure. We then proceed to discuss the actual rate increase request and our approach to its evaluation. II. BACKGROUND Golden Triangle Communications was awarded a franchise to operate a cable system in Denton, Texas in 1979. Golden Triangle Communications is a joint venture, 70 percent owned by Cox Cable of Texas, Inc., a subsidiary of Cox Cable Communications, Inc. and 30 percent owned by Golden Triangle Cummunic%- .ions, Inc., a subsidiary of Denton Publishing Company. Last January. Golden Triangle approached the City with a request co increase its basic service rate from $7.50 p-3r month to $9.95 per month. The City subsequently hired CTIC Associates to analyze the reasonableness of this request with the understanding that CTIC Associates would provide the City with ad,quate information to perform this analysis on its own in the future. z CTIC Associates requested that Golden Triangle Communications complete a set of forms which we have designed to obtain historical information on revenues, operating expense, capital expenditure and overall financial viability. The company waa also requested to provide S-year financial forecasts for these items. Golden Triangle Communications provided this information to CTIC Associates approximately cne month prior to the date of this report. III. DEVELOPING A REGULATORY PROCEDURE A well-developed ,ind clearly defined regulatory procedure is essential for local authorities attempting rate regulation AM can minimize the risk of legal battles with the cable operator. Courts will overturn a regulatory decision made by a local authority if it is found to be arbitrary. A clearly stated, predefined procedure may avoid such reversals. The Denton Cable Television Oidinance has very specific provisions for rate regulation. The most ;ertinent: provision to our presentation here reads as follows: "The criteria for the Council decision in such matt :s (rate increase requests) shall be establishment of rates which are "fair and reaouiiable" to both the Company and SOscribers and shall be generally defined as the minimum rates necessary to meet all applicable cost of service, including fair return an all invested capital, all assuming efficint and economical management." This provision states in a general way all of the important criteria for determining the need for a rate increase: fair and reasonable rates; adegUate return to investors; efficient and economicsl management. What is lackins is definition of these criteria. What is a fair and reasonable rate? What is an adequate return? How do you determina r~hather the company is operating efficiently? Wlfi~ 3 A. MEASURING EFFICIENCY By way of answering the last question first, whether the company is operating efficiently, we suggest that the City perform the following tasks as part of its future regulatory procedure. 1. Compliance Reviews Has the company complied with the ordinance? Has it completed construction. Is it providing the subscriber services it originally proposed? Periodic performance reviews which examine whether the company has ful- filled its obligations under the ordinance and delivered the level of services it originally proposed is an Important part of determining whether the rates are fair. Indeed, are subscribers paying for what they were promised or something less? If noncompliance is found, a rate increase (otherwise merited) may be denied until the problems are remedied, or the rate increase may be granted contingent upon compliance. 2. Measuring Subscriber Satisfaction Are subscriber complaints being handled in a timel; fashion? Are repairs made promptly? We have found that one of the most ccamon complaints about cabla operators is in the area of responding to customer service problems. Since the cable operator, in most instances, hes no direct competition, there is leas incentive for it to respond to service problems in as timely and efficient manner as if it were concerned about losing, subscribers to another operator. We recom- mend that a public record of subscriber complaints be mafntained. If there: appears to be a problem in this area, the operator should develop improved procedures before or as a part of au otherwise merited rate increase. 4 3. Naintainin Financial Records According to the Denton Cable Television Ordinance, the franchisee's accounting records should be available for City inspection. An annual exami- nation of these records will establish a number of important facts for deter- mining the need for future rate increases. (a) How has inflation affected operating costs? (b) Have there been any significant changes in corporate accounting procedure which might affect the individual system profitability? (For example, in its original proposal, Golden Triangle reported corporate overhead at around 2 percent of gross revenues. In its rate increase request, corporate overhead is charged at over 5% of gross revenues. This constitutes a signif- icant policy change.) (c) How does the company's financial performance compare with its initial expectations? Is the company doing better or worse Char expected? Denton is fortv,nate to have a fairly complete presentation of the company's initial finarncir.l goals in this company's original proposal to the City. This document should be used to compare actual results. For example, Golden Triangle has achieved the level of basic subscribe.rship it anticipated for this period and experts to achieve even greater subscriberahip in the future then it originally forecasted. In addition, pay service penetrations and revenues heve been greatly exceeded. Powever, costs have also greatly exceeded initial, expectations. (d) How doe3 the com,,any'e financial performance compare with industry :standards. One way to examine operator efficiency is to compare data for the partic- ular systen with national data. By developing comparative ration such as oi,irating expense per subscriber., the relationship between revenues and ?)lenses or pay service subscrfp,~ion, and evaluating these system ratios S against national or regional ratios, a municipality can estimate whether the system is operating as efficiently as other similar systems. If the system appears to be operating less efficiently, the City can encourage the operator to examine methods to improve operating efficiency. This type of effort by a municipality requires regularly collecting regional and national finan- cial data. This type of information cal be obtained from a variety of trade journals such as Paul Kagan's financial .-it:waletters or Warburg Paribus annu.nl publications, an well as, CTIC Associates. B. DETERMINING A FAIR LEVEL OF RF.TU%LN once local officials decide to evaluate a proposed rite increase, a principal task will be determining what Is a fair profit margin for the company. This task is one of the more difficult regulators undertake. The most common method is based on the company's rate of returr. Rate of return is a profitability ratio expressed nr a percentage that compares earnings to investment. Very briefly, the rate of return is net (perating income or net income after taxes divided by come base. Thin base may be assets, capital expended, net investment, a "rate base" or equity capital. Assets Include not only the equivalent of net investment in net plant, property and equipment, but they also include accounts receivable and other Lurrent assets plus any value attached to intangibles. Capital expenditure iu not reduced by the amount of depreciation already taken. Net investment is the original cos ,t of planL and equipment less accumulated depreciation. The rate base is the term most commonly used in regulated industries and is principally the net investment plus working capital. b Working (capital is necessary in any business and is added to net investment because of the time lag between billing and collection in most regulated companies. Equity capital is the portion of invested c:,,ital that comes from the entrepremeur's own pocket, as distinguished from borrowed capital on which the entrepreneur will need to pay the lender interest. For cable television, we believe the most appropriate base for the calcu- lation of the rate of return is either net investment or equity capital. Net investmeent represents the undepreciated portion of plant and equipment dedicated to public service. It has tho added advantage of being easy to establish in an audit and inventory of plant. The virtue of equ'.ty capital is that it theoretically represents the portion of investment that is at risk, thus tying in the rewards of enter- prise with the degree of risk undertaken. A problem with equity capital is that it is easy to play games with the equity portion of the capital, especially when there is c parent company that actually handles the financing. The parent company car. consider all the capital it advances to the subsidiary as equity, even whet, the major portion of these funds is borrowed. Also, equity capital is entitled to a higher rate of 7.eturn because it Is the risked portion of capital. The bank or the lender ulti- mately sesumes the risk on the debt portion of capital. Having discussed the advant.:hes and disadvantages of calculating the rate of return on either net investment or equity capital, and analyzing the varloua elements that are considered in defining economic viability, we believe the best definition of the economic viability of a project is one that enc m passes the earning of an adequate return on net investment. ~ssss■nss~~en~~s~~®rf~i~ 7 All that remains to make this into a working definition of economic viability is to quantify what is an "adequate" return. A rate of return that at least covers the cost of capital may be considered as adequate. Since all companies--including the franchisee compete in the open market for capital, there are costs associated with obtaining capital. The cost of the debt por- tion of capital is whatever interest rate the corrt,any will have to pay the lender over the term of the loan. The cost of equity capital is a prospective return on equity that would attract investors into channeling their equity funds towards cable television instead of some other venture. This normally entails more risk than investing in commercial paper or certificates of deposits. It is our estimate that over the next few years, debt capital would probably cost an average of 15 percent and equity capital should earn about 20 percent to remain attractive. Given a cost of capital estimate of 15 percent for debt and 20 percent for equity, we still need to reduce this to a composite cost of capital which would then be equated to what may be considered as an ade- quate rate of return. In the process of resolving the composite cost of capital, we also need to resolve the question of the proper debt-to-equity ratio. In eval+iating the financial structure of a proposed project, the analyst is confronted with the questions of the proper mix between debt and equity capital. Should it be the mix of capital shown in the application? Or should it be the capital structure of the parent company? As was mentioned before, the parent company usually does not earmark equity capita) from internally-generated funds or borrow separately for any specifi project such as Denton, Texas. 8 Nortially, with projects that will be consolidated with the parent's financial statements and taxes, the funds for a project such as Denton's are drawn from a pool for investment and the debt capital is drawn on a line of credit extended to the parent company and not specifically for the project in Denton. Therefore, the parent company can choose to regard any portion of the total funds advanced as either equity or debt. Another consideration for the City is that the higher the equity portion, the greater is the risk being assumed by the investor. But because equity capital costs more than debt capital, the rates will have to be higher than if more of the financing is assumed by debt capital. A certain clement of risk is necessary. After ill, no one would sell a bull ling or a piece of land to an investor for no money down. But how much risk is appropriate? Most banks and other lenders would like to see an investor shoulder at least 25 to 33 percent of a proposed cable TV project. Most regulated companies are required by the regulatory agencies to keop close to a >J/50 debt-to-equity balance. Thus with 40 percent equity and 50 percent debt, the cost of capital can bP coaaputed as follows. ' (1) 40 percent equity at 20 percent a 8.0 percent (2) 60 percent debt at 15 percent 9.0 percent weighted cost of capital - 17.0 percent With 50 percent equity, the weighted cost of capital becomes 17.5 percent. Using these assumptions we arrive at a rate of return that should not br less than 17 percent to cover the cost of capital. A company why is totally equity-financed would require a rate of return that would be in the area of 20 percent. This higher rate of return would be necessitated by the higher cost for equity capital. 9 CTIC Associates believes that the weighted cost of capital formula previously described is the most appropriate method of computing the cost of capital for gauging the rate of return for public companies. In what has come to be known as the PUC approach to calculating rate of return on net investment, many ublic utility commissions add-back interest expense to net income (after tax income) and divide this sum by net investment in plant. Most cable operators and other regulateu companies object to the treatment of interest expense--which is a real cash outflow--as a form of income. However, capital invested in cable plant is derived from two sources, debt and equity investors. Including both interest expense (the return to the debt holders or banks) and net income (the return to the equity investors) in the PUC rate of return formula, allows for return to both sources of capital invested. CTIC Associates uses the Public Utility Commission Method (PLIC) to calculate the adequacy of rate of return. So for, we have described the two most important aspects of developing a regulatory performance (efficiency) and a methodology for determining an ade- quate level of return for the operator (the PUC method). Having these two items incorporated into a regulatory policy will greatly facilitate the City's ability to approach a rate increase request. Our next step is to describe how we suggest to proceed with a rate increase request once presented. This begins with analyzing the financial status of the existing system. 10 IV. EVALUATING A RATE INCREASE REQUEST In order to determine whether a rate increase request to merited based on the existing level of return of the operator, the financial status of the system must be examined. This task involves a number of steps: 1) Collecting all rel..vant financial data from the operator; 2) Analyzing this data, verifying its accuracy and comparing it to initial expectations of the operator; 3 Identifying any irregularities or problems; 4) Determining whether the existing level of return merits a rate increase, and if so; 5) Determining exactly how great that rate Increase needs to be and comparing that to the level of rate increase proposed by the operator. A. COLLECTING RELEVANT SYSTEM DATA The basic function of rate regulation is to determine the revenue require- ment of the operator. The operator may set rates so as to generate sufficient revenues to a) cover all costs associated with the operation of the company and b) yield an allowed rate cf return on the operator's investet capital in the *usiness. The first step in determining the revenue requirement is to ascertaln all ailov the operating expenses, including maintenance, depreciation, interest, and taxes. if a procedure for reporting this information is set up at the Inception of the franchise, determining expenses Is a fairly easy task; otherwise, all financial information supplied by the operator should be docu- mented by audited financial statements. Capital Invested in the system should also be documented. it In order to collect this type of information, CTIC Associates has developed a set of financial report forms. Yhese report forms were presented to Golden Triangle Communications to complete. The financial report forms aT.! designed to collect all relevant financial data for the Denton operations including level of subscribership, sources and amounts of revernies, all operating expenses, capital expenditures and relevant accounting procedures. CTIC Associates prefers to examine a 10-year period when looking at the financial status of an operation. Typically, we request 5 years of historical data and request that the operator forecast 5 years into the future. We prefer to examine the financial status over a comparatively long period because the cable television industry lends itself towards long-term profit ratter than short-r1in gains. Operating a cable system is a very capital intensive process. Cable operators must invest thousands of dollars, otter, millions, initially and expect to absorb a few years of losses in order to achieve high levels of return in later years. This ii the basis for the 10 or 15 year franchise period typical in the industry. For this reason, examining only the first few years of operation can lead to misleading conclusions about financial viability. In the case of Golden Triangle, positive cash flow was experienced only last year. This is not uncommon for systems which are less than five years old and is consistent with Golden Triangle's initial expectations as expressed in the original proposal. It takes a few years for levels of subscritnrship to mature. As such, examining the past four years of its operation in conjunc- tion with the company's expectation of the next five years of operation yield a much more accurate picture of the system's overall profitability. 12 B. ANALYZING AND EVALUATING S'iSTEM DATA By way of demonstrating this task, we will analyze each major aspect of the financial operation of the Dentoa system. 1. System Revenues Revenue is the product of the number of subscribers tines the subscriber rates for each service offered. The number of subs,,.ribers is derived from the size of the market (the number of households in the franchise area) and the degree of penetration of that market for each type of service. Golden Triangle shows tl:e following results in households passed by cable and subscribership. Hanes Passed by Cable Originally Forecasted Currently Expected Actual 1982 1982 1988 _ 1988 19,000 18,000 18,000 21,923 Sub:;cribersHR Originally Forecasted Currently Expected Actual 1982 1982 1988 1988 Basic Service 93137 91000 10,000 13,153 Pay Service 13,585 60300 6,500 23,017 As illustrated above, Golden Triangle has schie!ved and slightly exceeded the number of homes it originally expected to pass with cable service and the number of subscribers it e;cpected to serve by this time. The most interesting fact is that initial pay service projections have been greatly exceeded. Pay service subscription is over twice what was initially forecast for this year and 13 expects pay subscription 'ay 1988 to be over three times what it initially forecast. There are probably two main reasons for this occurrence. First, the cable television industry has experienced much greater success with pay television subscription than initially expected. Newly built systems are achieving subscriptions of 2 pay services per subscriber and greater. This is a relatively new phenomenom. Second, Golden Triangle is offering more attractive pay services than initially proposed. In addition, it is offering HBO, at a moat attractive rate: $6.95 per month. This rate compares most favorably with many other systems where HBO is often offered at over $9.00 per month. These higher levels of subscribership mean that Golden Triangle is achieving and e-cpects to achieve much greater levels of revenue than it initially forecasted. Level of Revense ($000x) Originally Forecasted Currently Expected Actual 1982 1982 1987 1987 Basic Service 822 765 11010 1,725 Second Set 42 31 36 73 Installation 25 40 35 73 Pay TV 19340 555 604 30355 Total 2,313 11430 10731 5,294 Aside from the more optimistic subscriber results and forecasts currently made, part of the difference in revenue., projections is due to the inclusion of rate increases in the current rate increase ap+llcation pending. In its original proposal, Golden Triangle included one rate increase in forecast 14 year 6 (1984) for basic service: $7.50 per month to $6.50 per month. All other rates were held constant. In its current projections, Colden Triangle has included two increases in basic service rates: $7.50 per month to $9.95 per month in 1982 and $9.95 per month to $11.95 per month in 1985. It has also included substantial increases in the cost of pay services. Average Monthly Expenditure Per Subscriber Basic Service Per-Pay Service 1980 6.31 7.75 1981 6.79 8.00 1982* 8.41 8.95 1983 9.42 10.74 1984 9.42 10.74 1985 11.30 10.74 1986 11.30 11.98 1987 11.30 12.88 * Current year. These figures were derived from dividing annual revenue by annual aub- scribership and translating that figure into a monthly fee. There are a couple of notable items here. The previous table shows the averagt monthly expenditure per subscriber for basic service as below the actual rate. For example, in 1981 the average monthly expenditure per subscriber for basic service is $6.79 yet the actual rate is $7.50. Cox explains this discrepancy as an allowance for bulk dis- counts. The $8.41 per month figure for 19112 represents a weighted average of the $1.50 and $9.95 rate less allowance for bulk discounts. Bulk dis- counts are special rates given to multiple Units such as apartment complexes or hotels. As can be seen, a second rat: Increase is scheduled for 1985. 15 The second notable issue shown in the previous table is that not only is a $2.95 per month rate increase forecast for 1983, but also a $2.00 per month basic service rate increase is scheduled for 1985. It is interesting that Golden Triangle should include this second basic rate increase in its forecasts since it will be up to the City to make this determination. Substantial rate increases appear to be forecasted for pay services. The average cost of a pay service in 1982 was given as $8.95 per month. This is expected to climb to $12.48 per wonth by 1987, over a 50 percent increase. (Of course the City has no jurisdictioct over these rates.) This means that the subscriber taking basic service plus one pay service and currently spending around $16.45 per month, is expected to spend over. $24 per month for the same service by 1987 or `O percent more. The 1983 cost for this subscriber would be around $21 per month, Currently, subccriberu are purchasing on the average 1.5 pay services. Golden Triangle forecasts that by 1987 the average subscriber will be taking 1.75 pay services. This means that Colder, Triangle expects the average sub- scribers to be increasing the number of pay services it currently purchases. In sum, with respect to the level revenue currently being achieved and forecasted by Golden Triangle, we have the following information: 1) Golden Triangle is currently achieving basic and pay service subscription, and there- fore revenue, much higher than initially forecast; 2) its projections for subscribership for the future are much more optimistic than it originally anticipeted; and 3) it is planning t,) imple+aent two rate increases for basic and increase pay service rates re3ulting in an increase in average rates of over 50% over the next 5 years. In other words, it is expecting subscribErs 16 to spend more on cable service through both higher rates and increased purchase of service. 2. System Capital Expenditures The effect of capital expenditure upon the cost to the subscriber is indirect. The l,ivel of capital expenditure partly determines the revenue requirement of the cable operator and it is the revenue requirement which needs to be recovered by subscriber rates. Capital Expenditure ($AOOs) Originally Forcasted Capital Expenditure Capital Expenditure Currently Planned _.-al Ex enditure to Date to Date Ca.Pit M Antenna w%Tower 47.3 20 Micrcwave 50.6 45 15.0 70 1" Headend DiF,tribut io-a: 191 Aerial 1659.8 866 Underground 78.0 27,0 - Pole Arrangement - 106 _ Drops 651.9 173 153 Coaverters 566.6 541 1413 Buildings 196.0 " Leasehold 24.3 50 35 Program Orig- ination 285.2 Land 88.9 - b0 Test Equipment 62.9 75 - Vehicles 8.6 13 _ Preoperating - 69 Engineering - 63 Capitalized Overhead _ Capitalized Interest 46.7 _ Other 187.9 - Total 3968.6 2531 2045 MW WINE 17 Most notable is the fact it has cost almrst $1.5 million dollars more to construct this system than )riginally anticipated. The principal areas of difference ace the cost of distriL:.tion plant, drops and converters. a. Distribution Plant Miles of Plant Constructed 1979 1980 1981 1932 Total Original Proposal: Aerial 106 46 - - 152 Underground 14 4 18 Actual: Aerial 20,5 127.5 4.1 8.7 160.8 Underground - 23.5 11.9 4.8 40.2 As shorn, part of the increase cost of distribution plant is attributable to the fact that mope plant mi.las were needed than originally anticipated: twenty-two more underground miles and 8.8 more aerial miles. In its original proposal, Colder Triangle anticipated that aerial plant would cost around $6,000 per mile to construct. Underground plant was expected to coat $15,000 per mile or average. An overall pnr mile average was originally estimated at S6,306 per Tulle. Actual results, yield a $8,641 overall average per mile cost. (In its forms for rate increase, Golden Triangle did not break out distribution coats between underground and aerial plant.) Distribution costs have been approximately 23% 'nigher than ir.itial7.y forecast. Over the next six ycrers, Colder Triangle expects to construct 2 miles per year additional plant at an average coat of $16,000 per mile or 5192,000, In its original. proposal Golden Triangle inclwlad approximately $130 thousand for additional plant miles, but did not list any sdditi.onal plant miles after inttial construction. 18 b) Drops ar.d Converters -ne of the most significant areas of increased capital expenditure over initial expectation is in the area of drops and converters. In its original proposal, the average coat per subncriber for drop and converter appear to be around $77. The actual costs seem closer to $130 per subscriber for these two items. In eddition, in its original proposal Golden Triangle Includes $578 thousand for additional drops, new zonverters and replacing converters after 1982. Golden Triangle now projects that these items will cost approximately $1.6 million. However, we question the amount it is budgeting for converters. Cox indicates that the average cost of its converters is around $80 per unit. It further indicates that a 10 percent inflation rate was incorporated into these projections. One other varie.tion with the. initial proposal is the inclusion of capitalized interest. In its initial proposal Golden Triangle showed no capitalized interest. however, in 1979 and 1980, the Denton system was charged capitalized interest--the total amount chargee.. was $46.7 thousand dollars. To summarize, Golden Trianglc has found the Denton system somewhat more expensive to build than initially anticipated. Thi-, is due to both 14 gher per unit costs and greater mileage, and higher levels of subscribership. We hav,i no significant problems with its repoztinp, or forecasting except with zespect to its convertftr replacement budget. 19 3. OEerating Expenses operating eKpeases are thy: day'-to-day expenses for wages, benefits and all other items that a business incurs. In the cable industry, annual operating expenses are often broken down into three categories: plant expenses, operating expenses and general; selling and administrative expenses. a) Plant Expenses Under the category of plant expense, the actual experiences of Golden Triangle compares favorably to its initially expected plant expense. Salaries and benefits are comparative. A number of items including converter maintenance, power and vehicle expense are considerately Less than originally forecasted. Golds--n Triangle has forecasted a reYatively high level of inflation over the next b years averaging around 10 percent per year. b) Origination Expenses Origination expenses, excluding pay cable are considerably higher than originally forecasted. The source of this difference is largely salary and benefit costs, which are over twice what was originally forecast. Pay cable expense is of course much higher than originally forecast due to the higher levels of subscription than anticipated. c) General, Selling and Administrative Expenses. General, selling and administrative expenses ate also much higher than originally forecast. This is again partly due to the fact that a number of 1 GS&A related expenses are determined by th,e level of revenue achieved. It:eae items include bad debt expenso, taxes, franchise fee and corporate overhead. 20 Aside frog these revenue related items, a number of expenses are actually lower than expected originally; power, rent, vehicle expense, professional services, advertising, insurance, and fees. As stated earlier, we do notice a significant policy change which has affected the GSSA category expense: namely corporate overhead. In its applica- tion, Golden Triangle indicated it would purchase accounting services from Cox. It estimated the coat of these services between $20,600 per year and $28,700 per year over the franchise. According to the rate increase request forms, corporate overhead is now being charged a. a 5 percent of gross revenues. In addition, the system is being charged a divisional fne of $6,930 (based on 1/2 annual salary of a general ledger accountant at $6,330 plus $600 annual cost of data processing reports). This fee is to be increased 10 percent annually. The City may wish to clarify exactly what services are being provided by Cox for this 5% management fee. In almost every municipality we have worked with the rate regulation and renegotiation process, the issue of the reasonableness of the corporate over- head amount has arisen. Corporate overhead should not be permitted to include any profit to the parent company. It should simply represent compensation to the parent company for services rendered to the local systev. One way to guage the reasonableness of the corporate overhead amount is to compare: it to the amount that a stand-alone system would have to pay if It were to purchaso the services now provided by the parent company. Typically, these services are-, purchasinf;, engineering, accounting, data processing, lcg"l and pro- gramming services, but can also include a wide variety of other services. 21 Over the past three years, the Denton system hits paid out over $258 thousand in corporate overhead. Yet, included in GSSA budget are substantial funds for data processing, professional services, programming and marketing personnel. d) Operating Expense per Subscriber and Operating Ratio Two popular measures often used to compare relative efficiencies of cable TV operations are the total operating expense per subscriber and the operating ratio. The operating ratio is obtained by dividing operating expense by revenue. An operating ratio in the range of 55 percent to 65 per- cent is common in the cable television industry but any ratio much higher than 65 percent may be suspect of either inefficient operation or adequate rates. The follpwing table compares the operating expense per subscriber without pay television expense. Pay television expense is removed to facilitate a more accurate comparison since these costs are directly related to pay tele- vision revenue. Operating Expensz '.'er Subscriber Actual Average Over Past Initial Projected Average 3 Years of Operation Over Paet 3 Years of Operation $126.73 $91.42 On a per subscriber basis, we see that overall operating expenses per subscriber are 39% higher than anticipated for this period. The operating ratf.o, the relationship between operating expense and the revenue it generates, can be seen below. 22 Actual Average Operating Ratio Over the Past Initial Projected Average _ 3 Years of Operation Over Past 3 Years of Operation .92 .73 As can be seen, even though the level of revenue achieved is considerably higher than was initially projected, costs associated with collecting that level of revenue are even proportionally higher. 4. Conclusions In this sectior of the report, we have presented an analysis of the financial data we have received from Go?&en Triangle. In general, we found no problems with the accuracy of the data submitted and few problems with the financial forecasts. We can summarize the results of our analysis of the financial data in the following way. Golden Triangle has met and exceeded the subscriber and revenue projections it anticipated when it accepted the Denton franchise. Indeed, it appears more optimistic about the future levels of revenue than it did 4 years ago. However, it appears that these higher levels of revenues are matched with even higher expenses. ;:n the next sectior, we examine the overall level of profitability, and how it compares with the companies initial expectations. C. THE RATE Of RETURN In Section III of this report, wa discuss our method for calculating rate of return and measuring its adequacy. To summarize this approach, CTIC uses a 23 Public Utility measure of rate of return which relates return to equity inves- tors (net income) and return to the debt source (interest expense) to the net invested capital. Net investment represents accumulated capital expenditures less accumulated depreciation. When we approached the rate of return calculation for this project we examined the 9 years of data information we received; 4 years of historical data and 5 years of forecast data. This is because it is more realistic to examine a level of return over a 9-year period than just the first 4 years of operation. A cable company cannot expect to be receiving a level of return commensurate with its cost of capital when its system is only 4 years old. 1. Net Investment in Plant--The Rate Base Over the period examined, we found that the net investment of the Denton System will average the following amount on an average annual basis would be $2,452 thousand. This value includes Golden Triangle's assumption of needed capital expend- iture and relates depreciation expense over the next 5 years. As we stated earlier, we have some question as to whether the level of capital forecasted for converters will in fact be necessary. For future regulatory purposes, we suggest that the City keep a watchful eye on how closely those projections are realized. 24 2. Level of Return to investors As discussed in Section III, the sources of cv.4 tal are equity funds and loans or debt. The return available to equity investors is net income. The return to the sources of debt is the interest expense charged on the loans. Over the 9-year period that we examined, the company reports the following average annual net income: Average Annual Income Statement ($OOOs) Revenues 2871 Operating expense: Plant expense (308) Origination expense (1109) GS6A expense (643) Corporate overhead (152) Total expense (2212) Operating income 659 Depreciation expense (393) Interest expense (122) Pretax income 144 Federal tax (50) Net income 94 It is important to recall that the level of re,,%nue and expenses represented here include Golden Triangle's proposed rate increase as well as a future rate increase. This average net annual net income and interest expense yield the following rate of return or net investment. Rate of Return Calculation ($0009) Avg. Net Income (plus) avg. interest (divided by) Net Investment (equals) Rate of Return 94 + 122 2452 8.8% 25 3. Adequate of the Return The balance sheet of the rate form shows an average debt to equity ratio of approximately 1:7. Average interest rates over the period examined was assumed by the company to be around 15 percent. As such, the average weighted coat of capital is around 19%, assuming the cost >f equity capital to be around 20%. The erpected return on net investment falls short of the cost of capital even with both basic rate increases forecasted as well as the pay service rate increases forecasted. V1. RECOMMENDATIONS We believe that the financial data submitted by Golden Triangle supports its request for a basic service rate increase. However, the financial pro- jections of the applicant have been slightly distorted due to the inclusion of two basic rate increases as well as several pay servicf- rate increases. Our recommendation is that the City of Denton grant Golden Triangle Communications a rate increase of $1.50 to $1.75 per month. In other words, allow the operator to increase basic service rates from $7.50 per month to $9.00 or $9.25 per month. This increase along with the scheduled pay service rite increases should serve to substanrially improve the profitability of the system. The reason we do not recommend the full $2.45 increase in because the operator has included rather high forecast of inflation and capital items in the future. We believe. that the City as part of its attemp•.3 to develop a more complete regulatory effort, should monitor these costs carefully over the next few years. This can be done by requiring detailed financialt report- ing on an annual basis. Actual costs can be compared to the forecasts 26 presented here. If the City finds that the level of inflation and expenditure approach these forecasts, the City might consider granting the additional amount of the requested increase. A second reason why we do not recommend a full $2.45 p(;r month increase is because we question whether it may have some negative impact on subscrip- tion to cable service. A $2.45 per month increase means that subscribers will be cpending $29 more for basic service every year. This additional cost coupled with what appears to be an expectation that the average subscriber will be spending an additional $36 a year on pay services may result in some sub- scriber drop-off. Such a drop-off could negate the positive effects of increasing rates. We have one final comment concerning the corporate overhead allocation. Since the 5 percent plus management currently being charged wea not part of the original application, the City may deride to consider only the original level forecasted for rate making purposes. In other words, the City might only allow a corporate overhead amount in the range of 2 percent for the purpose of establishing the level of return. If we adjust the average net income for this amount, our calculations would yield a rate of return around 10 percent. This adjustment would not alter our conclusions about the merits of this rate increase. However, it might have some impact on future rate increase. requests. Our findings here are based solely on the financial data we hive received. They do not consider soave very important criteria for determining the a; ropri- steness of a rate increase request; namely operators' compiianco with 27 ordinance and general subscriber satisfaction. Before taking any final actio» on this proposal, we strongly recoamend that my substantial problems with C•)Iden Triangle's performance be identified and efforts be made to resolve these problems before any rate increase is formally approved.