Review of the financial terms for the extensions to the independent national radio licences: a consultation on the methodology

Summary

1.1 This Statement sets out Ofcom’s valuation methodology for the financial terms to be applied to the potential extensions of the three licences (Classic FM, Virgin Radio and talkSPORT) relating to independent national radio services (INRs).

1.2 On 16 November 2005, Ofcom issued a consultation seeking views on the proposed valuation methodology[ ^(-1-)] (“the Consultation”)

Overriding Objective

1.3 Ofcom’s overriding objective is to determine financial terms for the licence extensions, through determining a fair and reasonable value based on a methodology which is consistent with its statutory obligations. This involves consideration of the likely outcome of competitive auctions, similar to those staged in 1991 and 1993, albeit on a basis subject to a number of statutory and practical constraints. The terms for the extension should be set in accordance with an objective process which:

• “.. ensure[s] that the tax payer gets a proper return for the use of the valuable and scarce national resources constituted by broadcasting rights and, in particular, the use of the frequency spectrum” [ ^(-2-)]; and
• enables Ofcom to set terms that are reasonable within the context of the current market environment and that will continue to be reasonable for the extended period of the licence.

1.4 However, it is important to recognise the very wide range of uncertainties that Ofcom faces in arriving at its determination. The uncertainties include, but are not limited to, the following:

• future trends in radio advertising revenues;
• the likely size and speed of structural change in the industry including that associated with digital switchover; and
• future decisions on digital switchover.

1.5 The requirement for Ofcom to consider the outcome of a hypothetical single round sealed bid auction adds a further layer of complexity. Neither the exact circumstances of the auction, the identity of bidders, their business plans nor their bidding strategies can be predicted with certainty.

1.6 Ofcom is unable to eliminate these uncertainties. Therefore, in order to fulfil its statutory duty to determine the financial terms, it is necessary for Ofcom to make a series of assumptions on many issues.

1.7 Ofcom believes that the methodology outlined in this statement is compatible with both Ofcom’s objectives and statutory duties. Ofcom recognises that there may be alternative approaches to individual elements of the valuation methodology but considers that, taken as a whole, the methodology should provide a fair and reasonable result, which Ofcom can use to inform its estimate of the Cash Bid (the fixed payment) and determination of a PQR (being the Percentage of Qualifying Revenue which must be paid.)

Statutory requirements

1.8 Section 253 of the Communications Act 2003 (the “Act”) allows holders of an INR licence to apply to Ofcom for an extension to their current licence for a period of up to four years.

1.9 Under the Act, the earliest date on which a licensee can apply for an extension is three years prior to the expiry date of its licence. The latest date a licensee can apply for an extension is three months before the day Ofcom would need to publish a notice under S98(1) of the Broadcasting Act1990 Act (“1990 Act”). This is the “Relevant Date”. Ofcom has set out the Relevant Dates in the table below. As detailed elsewhere in this document, the relevant date for Classic FM differs from that set out in the Consultation;

1.10 Under Section 253(8) of the Act, following an application for an extension, Ofcom must determine a fixed annual cash amount (the “Cash Bid”) to be paid for the licence and may set a revised Percentage of Qualifying Revenue (PQR) for each year of the extended licence period. Specifically, in respect of the Cash Bid, the Act requires that Ofcom determine the amount that, in its opinion, would have been the Cash Bid of the licence holder were the licence being granted afresh. This means that in respect of the Cash Bid, Ofcom is required to consider the effects of a hypothetical auction of the licences.

1.11 In the event that a licensee does not apply for an extension or, alternatively, does apply for an extension but does not consent to the terms subsequently notified, then the licence will expire on the licence expiry date shown above. Ofcom would take steps to utilise the relevant frequency in a way consistent with both Ofcom’s stated policy objectives at that time and the statutory obligations upon Ofcom.

1.12 In the event that a licensee applies for an extension and accepts the revised financial terms offered then the duration of the licence will be extended for a period of up to four years. The licence will then expire at the end of the extension period and Ofcom will take steps to utilise the relevant frequency in a way consistent with both Ofcom’s stated policy objectives at that time and the statutory obligations upon Ofcom.

Context

1.13 Ofcom believes that it is important to take into account in the valuation methodology the various changes that have occurred in the broadcasting environment since the original auction of the licences in the early 1990’s and when the licences were renewed by the Radio Authority in 1999 and 2000. Ofcom believes that its approach reflects this aim.

Summary of Conclusions

1.14 Ofcom received three detailed responses to the Consultation, all of which were confidential. The same three respondents also submitted a joint confidential response (the “joint response”). Ofcom has taken account of the responses and, as a result, some of the original proposals have been modified. The key points made in the responses to the Consultation are referred to throughout this statement.

1.15 The Act is not prescriptive about the specific process that Ofcom must follow in order to determine the amount that would be bid for each licence in a competitive tender. Therefore, it is necessary for Ofcom to establish the circumstances of the hypothetical auction process that Ofcom aims to consider in the reviews and the corresponding valuation methodology.

1.16 Ofcom considers that when considering the outcome of a hypothetical auction it would replicate the following circumstances:

• As required by the s98 of the 1990 Act, Ofcom would design a sealed-bid auction in which the highest bidder would win the licence.
• The auction would be designed, within the framework of the statute, to recover the maximum possible value consistent with the highest bidder being able to fulfil the format and other requirements of the licence.
• The amount the incumbent would bid in a competitive auction would be the minimum required to beat the second-highest bidder, and as such would not necessarily represent the maximum amount the incumbent would be willing to pay. The difference between the value of the licence to the incumbent and the value of the licence to the second-highest bidder should equal approximately the cost of entry.

1.17 On this basis, Ofcom will use the following approach when considering the valuation of the licence extension and when considering revised financial terms. This valuation is intended to meet the requirements of the Act in relation to determining the Cash Bid, and also to provide a robust basis for informing Ofcom’s decision as to the appropriate level of the PQR.

• Ofcom considers that the value of the licence to a bidder would equal the net value of the rights and obligations associated with the licence.
• In order to determine the amount of the second-highest bid in an auction, Ofcom will estimate the net present value of the licence to the incumbent and then adjust this value downwards to reflect the reasonable additional costs of entry that a new entrant might incur.
• All profits made from providing a national analogue service will be attributed to the licence. Ofcom will value the national analogue element of the licence by using a discounted cashflow forecast to estimate the present value of the expected cashflows attributed to the analogue service over the relevant period.
• In order to forecast cashflows for the national analogue service, Ofcom will allocate costs and revenues that are common to the national analogue, local analogue and digital platforms. Ofcom will allocate these costs and revenues on the basis of a measure of listening on each platform. Ofcom will give consideration to the appropriate weightings that could be applied to each platform, based on representations made by applicants for an extension and other available information.
• A broadcaster does not need a national analogue licence to provide a national digital service, as this right can be obtained by acquiring a digital sound programme service licence and negotiating for carriage on the national digital multiplex and other digital platforms. Therefore, it would not be appropriate to attribute the revenues and costs from the digital services to the national analogue licence. However, simulcast of the national analogue service on the national digital multiplex is a requirement upon the licensees which will be required for the duration of the licence extension. To the extent that this obligation appears commercially onerous, Ofcom will take account of this obligation in its valuation of the licence.
• The licence will be valued through a discounted cash flow of a 12-year licence. Payment terms for a 12-year licence will be derived from that valuation. These payment terms will then be applied to the revenues expected to be generated by the licensees during the four-year extension period and the total value of payments will be determined. Terms will then be offered to the licensees which are expected to recover, in total, the same amount as the total value of payments described above.
• Ofcom will use a nominal, pre-tax discount rate of 15% for the valuations.
• Ofcom will set the relative weighting of the PQR and Cash Bid in its determination, but notes that respondents to the consultation specified a preference towards terms which recover a high proportion of the total value of the licence through the PQR element of the payments.

Footnotes:

1.- Ofcom Publication; Consultation on the methodology for the review of financial terms for the extensions to the independent national radio licences, 16 November 2005

2.- David Waddington (then Home Secretary) on 18 December 1989, when speaking in the Commons debate on the Bill which was to become the Broadcasting Act 1990

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