Cable firms pose valuation riddle: With flotations on the way, Gail Counsell finds analysts evolving complex new methods of calculation

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The Independent Online
WHAT price a slice of a loss-making cash-guzzling, incomplete cable network? The question will be asked with growing urgency over the next few months.

A flood of British cable companies is due to arrive on the London stock market this year as their (largely foreign) parents seek to establish book values for their offspring and to guard against any xenophobic regulatory tendancies in a future UK Government.

Floats of minority stakes in American-owned TeleWest, the largest UK cable company, and French-owned General Cable, the seventh largest, are on the cards for June. If they go smoothly, others seem certain to follow.

Since the upfront costs of cabling a franchise area are enormous, no British cable company has yet turned in a profit - nor will they for years to come. But that will not stop TeleWest, which had 1992 revenues of about pounds 20m, attempting to obtain a market valuation of around pounds 1.85bn - a modest turnover multiple of 92 times.

Given that traditional methods of valuation are largely irrelevant, analysts have been scratching around for alternative ways to attach a price to these companies.

Until recently the usual approach was a crude one. Analysts would look at how many homes had been or could be cabled in a company's franchise and attribute a relatively arbitrary value to each.

But the prospect of flotations has inspired much more complex valuation methods. The current favoured solution is to work out their projected earnings before interest, tax, depreciation and amortisation - essentially free cash flow - over the next 10 years or so.

This is then 'discounted' - reduced a little - to reflect the fact it will not be earned for some time and then a multiple applied to the end result to achieve a stock market valuation. All of which entails an awful lot of guesswork.

It means assigning numbers to the cost of cabling franchise areas, the rate at which households will take up the offer of having cable television and/or telephone services, subscription rates, programming and telephone connection costs, to mention just a few.

Kleinwort Benson, TeleWest's adviser, has produced a projection that suggests the company will have revenues of pounds 1.3bn and pre-tax profits of pounds 389m - in the year 2004. Applying an exit multiple of 10 times and a 16 per cent discount rate, TeleWest would thus be valued at pounds 1.3bn.

Using a different key variable - say the exit multiple or the discount percentage - makes a huge difference to the valuation. On Kleinwort's figures an exit multiple of 12 and a 14 per cent discount rate would push the value up to pounds 1.9bn.

Since there are virtually no British companies that are comparable investments, analysts have used the multiples that apply to quoted US cable companies.

Some - such as Kleinwort - say that British cable companies are more attractive than their US equivalent since they alone can offer highly profitable telephone services. So, according to Kleinwort, a multiple of 10 times 2004 cash flow, about 25 per cent higher than the average US figure, would be justified. At a 16 per cent discount rate this produces a value of pounds 1.3bn, at 14 per cent pounds 1.59bn.

Kleinwort goes further, however. It says that the cable industry is more like the UK cellular industry - Vodafone - than it is like US cable companies. And Vodafone trades on a multiple of 13.6. So it suggests that an exit multiple of 12 times - which would give a market value of between pounds 1.58bn and pounds 1.9bn - might also be justifiable.

But, if that is tricky enough, factoring in the business assumptions is horrendous. Goldman Sachs, another adviser to TeleWest, works on the basis that by 2003 more than 66 per cent of British homes will be passed by cable, 2.5 million of them in franchise areas controlled by TeleWest, and 45 per cent of these will subscribe to cable TV.

Goldman also assumes that 33 per cent of homes and 20 per cent of businesses will take residential telephony services.

Yet at present only 2.9 million homes have been passed by cable, with 519,000 subscribers signed up, a penetration rate of only 20 per cent - though admittedly cable companies have had spectacular success in attracting telephone subscribers.

Many other risk factors cannot be incorporated into the numbers but could gravely upset the calculations. A future British or European government might be more nationalistic, might allow BT to compete more directly or might impose high taxes on cable companies if they looked too profitable.

Then again, BT might launch a rate price war - at present cable telephony undercuts BT by 10-15 per cent. Or, again, the costs to the cable companies of connecting with BT's systems may rise.

Like the rain that made Euro Disney visitors stay away, or the collapse of the ERM that made its prices soar, none of these risk factors is quantifiable, a probable reason why Kleinwort and Goldman have produced remarkably similar projections for TeleWest.

Investors should clearly be sceptical. So perhaps a better approach to valuation is the qualitative one offered by Neill Junor, an analyst with NatWest Securities, which advises General Cable. 'The trouble with a model is that you have to make so many assumptions,' he points out. 'At least some of the key ones will be wrong.'

Instead, he says, start with the assumption that the cable industry has a lot of things going for it and that is probably enough to ensure its overall profitability.

Then assume that at least some of the companies will be very successful and try to pick the winners.

'We have looked at how many customers they have or could have, how fast they are likely to build, how many businesses could be connected and so on,' he says.

Then look at the risks - which he admits are huge - and see which company you feel most comfortable with in terms of minimising those risks.

'It isn't a substitute for numbers, but it is a useful adjunct to an otherwise very intangible valuation model,' Mr Junor adds.

(Photograph and graph omitted)

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