Pay TV phase three document - Stakeholders - Ofcom

Pay TV phase three document – non-confidential version
may be considerable uncertainty about a new business model 445 . It is much less of a
concern when looking at an established firm with relatively little risk of failure.
6.191 When looking at Sky’s historic returns, we need to be aware of the danger that
returns may appear excessive, but that they in fact reflect an outcome in which actual
(ex post) returns are above historical (ex ante) expected returns purely because a
risky business has succeeded. Hence although we observe that Sky’s historic returns
for the period 1995-2008 appear relatively high, we need to accept that they may
reflect this type of outcome. In the early part of the period, Sky’s business model was
unproven, and there may well have been substantial downside risks for which
investors needed to be compensated.
6.192 However, when we consider Sky’s more recent returns, concerns about potential
failure are far less relevant. Sky has a proven business model, its risk of failure is low
and we do not anticipate an outcome in which it is likely to face substantial stranded
costs. Hence on this basis, we consider that it is appropriate to compare the IRR that
Oxera has derived with a forward looking WACC.
6.193 Our forward-looking estimate of Sky’s cost of capital, set out in Annex 10, is 10.3%.
We would suggest that this is the relevant benchmark for looking at Sky’s IRR for
future years, but is also a reasonable estimate of Sky’s cost of capital in the last few
years, including the 2004 – 08 period that Oxera have considered.
6.194 We believe that Oxera’s analysis provides evidence that if the pay TV market is left
unchanged, Sky’s future IRR (based on ongoing profitability and the value of its asset
base) would be likely to exceed its cost of capital.
Disaggregated profitability
6.195 We also asked Oxera to consider the profitability of Sky’s wholesale and retail
businesses separately, and to look separately at the profitability of Sky’s wholesale
movies and sports activities. On the former, Oxera concludes that “[r]eturns for Sky
wholesale activities appear higher than for Sky retail activities. These results seem
robust to a number of cost allocation approaches and sensitivity checks.” Specifically,
Oxera found that Sky’s wholesale operation has an estimated IRR of [ � ]%, higher
than its retail operation ([ � ]%), both based on replacement cost of assets 446 .
445 While this is formally the correct way to address the risk of failure, it can be extremely difficult to
determine the probabilities that should be attached to particular cashflow projections. As a result
companies frequently address failure risks in a more simplistic way, by using a hurdle rate of return
that is somewhat above their WACC.
446 These figures are based on Oxera’s own “high level” cost allocation between wholesale and retail
activities. They are supported by calculations based on Analysys Mason’s bottom-up cost allocation
which also show that wholesale returns are higher than retail returns. However, the Analysys Mason
allocation results in higher returns for both retail and wholesale businesses. This is because although
revenues are the same as in the “high level” approach, the alternative calculation excludes some non-
TV costs that cannot be identified at a higher level of disaggregation. In other words, the calculation of
returns under the Analysys Mason cost allocation includes some non-TV revenues, but not the
associated costs. This overstates the overall returns, but is nonetheless informative with respect to
relative wholesale and retail returns. We would expect all of the non-TV revenues to apply to Sky’s
retail business. Exclusion of these revenues would reduce Sky’s retail returns, but leave wholesale
returns unchanged. Hence the conclusion that wholesale returns are higher than retail returns
appears robust.
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