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PWC review
113-119 The Terrace
PO Box 243
Wellington
New Zealand
Telephone +64 4 462 7000
Facsimile +64 4 462 7001
Brian Miller
Ministry of Economic Development
33 Bowen Street
Wellington
2 November 2007
Dear Brian
Renewal of management rights for cellular services (800/900MHz) calculation of renewal prices: Review
In accordance with our contract, we have reviewed the draft Network Strategies report Renewal of Management Rights for Cellular Services (800/900MHz) – Calculation of Renewal Prices.1 The purpose of the review was to assess the alignment between the methodology used by Network Strategies in the report and that specified by Cabinet (http://www.med.govt.nz/templates/ContentTopicSummary____19223.aspx.)
The methodology specified in the Cabinet paper involves the application of an incremental optimised deprival value approach (incremental ODV). This methodology was developed in concept by PricewaterhouseCoopers and NZIER.2 Top
Limitations and exclusions
We are unable to comment on any engineering/technical matters relating to network design, technology or other relevant topics. Further, we have not reviewed Network Strategies’ assumptions or the workings of its financial model or other calculations. The scope of our review is therefore necessarily limited to assessment of the broad alignment between the methodology approved by Cabinet (which was created at a conceptual level only) and that presented in Network Strategies’ report (a detailed implementation of the conceptual methodology).
This letter should be read in conjunction with the important notice contained in Appendix A.
Work undertaken
We have:
- Reviewed Network Strategies’ report;
- Attended a meeting with Network Strategies to ask a number of questions;
- Provided further questions to the Ministry and Network Strategies by email.
- We have not seen a list of the assumptions used by Network Strategies in developing its model and the pricing recommendation.
Review and findings
Our review and findings are specified below.Alignment with specified methodology
Overall, the Network Strategies methodology is consistent with the incremental optimised deprival value approach that Cabinet agreed should be used to determine the offer prices and conforms to the specification of the methodology set out in the PricewaterhouseCoopers/NZIER pricing methodology discussion paper. There are two instances where Network Strategies has departed from the specification of the methodology in the discussion paper:
| i) | Specification of the pre-deprival spectrum package |
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The original methodology indicates that this needs to be the spectrum package required for the lowest cost network. The Network Strategies methodology specifies the pre-deprival spectrum package as an input. |
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We have discussed this matter with Network Strategies. It was explained that Network Strategies’ modelling predicted that there was no “lowest cost” combination of network and spectrum package – as available spectrum increased, it was possible to design a marginally less expensive network. Network Strategies stated that plotting a graph of network costs against spectrum package did not produce a minimum point. |
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Network Strategies has therefore specified a range of starting packages of between 10MHz and 15 MHz paired spectrum in the 800/900MHz bands. We understand that Network Strategies considered the amounts of spectrum typically available to operators around the world. The allocation of 10MHz was considered consistent with general international practice. Larger packages are more consistent with the packages that New Zealand mobile operators have had historically and, as advised by the Ministry, are likely to hold in the future. |
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Given that it was not possible to define a pre-deprival spectrum package by reference to the “lowest cost” network, it is logical to take an alternative approach. The use of existing examples around the world and amounts that are consistent with available spectrum are logical benchmarks. The choice of the range of 10MHz to 15MHz paired spectrum appears to be a matter of judgement. While it is a relatively generous amount of spectrum by international standards, it is not inconsistent with the larger packages held by New Zealand mobile operators. |
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We note that under the Network Strategies modelling assumptions, the larger the spectrum package the lower the calculated cost of renewal. Hence, using a package size more consistent with New Zealand practice produces a lower cost of renewal than if a package size more consistent with international standards is used. |
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| ii) | Expected Value Calculation |
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The original methodology suggested as a final step performing an Expected Value calculation against a range of scenarios for the valuation. This has not been performed, although sensitivity testing has been undertaken. Network Strategies noted that given the high levels of uncertainty around the demand forecasting exercise, it was not possible in practice to assign probabilities to specific scenarios. |
Other observations Top
| i) |
The approach taken by Network Strategies has been, for each starting spectrum package, to cost the network build and operation in the pre- and post-deprival scenarios, rather than cost the build of the base package and then the subsequent investment if the generic operator were then deprived of some spectrum. |
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The approach taken can be assumed to proxy how a new entrant, knowing the available spectrum package, would design a network to utilise that package efficiently. |
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| ii) |
The generic operator is assumed to have spectrum holdings in the 800/900MHz band and the 2GHz band. In discussions with Network Strategies we ascertained that the 2GHz band is assumed to only be used in urban areas. Network Strategies assume that a specific proportion of the generic operator’s traffic is always carried in the 2GHz band, in un-deprived and deprived scenarios. It would be expected that an operator in the deprived scenario would seek the lowest-cost solution to meeting demand for its services and that diverting some traffic onto the 2GHz network might be one approach to this. This has not been modelled. |
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Network Strategies explained that there would have been a large number of factors affecting whether diversion of traffic onto the elements of a network using the 2GHz spectrum would be a lower or higher cost solution to the deprival problems. In the interests of simplicity, it was decided to not to model this. We are not able to say what the impact on spectrum valuation might be of actively modelling the 2GHz traffic as well. |
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| iii) |
The spectrum management rights are to be renewed on differing dates, but will have the same end date. The renewed rights therefore have different durations (ranging from 19 years and 2 months to 20 years). We understand that Network Strategies' recommended price range is based on modelling a 20-year scenario for the rights. It would be expected that 19-year and 20-year rights would have different values, even if only as a function of discounting cash flows over different periods. It would therefore be appropriate for the Ministry to consider making some adjustment to the recommended price range to reflect, where relevant, the shorter duration of some of the rights. |
Impact of potential offer prices on the operatorsTop
You have also asked us to consider the impact of the potential offer prices on the operators’ businesses. We understand that the renewal amounts of spectrum are likely to be approximately 15MHz paired for both Telecom and Vodafone. The following table shows the range of prices per MHz paired that might be applied, based on scenarios for pre-deprival spectrum holdings.
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Pre-deprival scenario (MHz paired)
10 12.5 15
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| Offer ($/MHz Paired) | 2.1 3.8 7.8 |
The following table shows the range of total prices arising implied by the renewal package and the range of offer prices recommended by Network Strategies, assuming a 15MHz paired renewal package.
| Renewal (MHz Paired) |
Pre-deprival scenario (MHz paired)
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| Offer per operator ($m) | 15 | 31.5 57 117 |
Telecom's latest accounts split out mobile revenue (but not mobile interconnect revenues), but do not provide any other segmental data about the costs of the mobile operation, so there is no way of comparing the total renewal cost with current profits, cash flows or invested capital.
Vodafone’s latest filings with the Companies Office, for the year to March 2007, show profit after tax of $161.5 million for Vodafone’s main operations,3 and a further profit after tax of $6.4 million for a sister company that manages the group’s New Zealand spectrum rights.4 On this basis, the recommended pricing range and expected renewal package would produce a renewal cost ranging between approximately 18% and 70% of Vodafone’s latest reported post-tax annual profits.
We have no evidence to suggest that the renewal price would cause either party to close their mobile operations. However, there is no way of telling how the proposed renewal price might affect future investment decisions.
GeneralTop
If you have any questions on the above, please do not hesitate to contact Bruce Wattie or Richard Forgan.
Yours sincerely
Partner Partner
Appendix A
In preparing this letter and forming our opinion, we have relied upon, and assumed the accuracy and completeness of, all information available to us from public sources, interviewees and furnished to us by the Ministry. We have evaluated that information through analysis, inquiry and review but have not sought to verify the accuracy or completeness of any such information. It should not be construed that we have conducted an audit of the information we have used.
This letter has been prepared solely for the use by the Ministry, but we acknowledge that it will be published by the Ministry on its website. We will not accept responsibility to any party other than to the Ministry, to whom our letter is addressed. We will accept no responsibility for any reliance that may be placed on our letter should it be used for any purpose other than that for which it is prepared.
Our letter has been prepared with care and diligence and the statements and opinions in the letter are given in good faith and in the belief on reasonable grounds that such statements and opinions are not false or misleading. No responsibility arising in any way for errors or omissions (including responsibility to any person for negligence) is assumed by us or any of our partners or employees for the preparation of the letter to the extent that such errors or omissions result from our reasonable reliance on information provided by others or assumptions disclosed in the letter or assumptions reasonably taken as implicit.
We reserve the right, but are under no obligation, to revise or amend our letter if any additional information (particularly as regards the assumptions we have relied upon) which exists on the date of our letter, but was not drawn to our attention during its preparation, subsequently comes to light.
1 Network strategies report number 27019.30 October 2007
2 "Renewal of spectrum rights for cellular services - pricing methodology - discussion paper" July 2006
3 Vodafone New Zealand Limited, Annual Report 2007
4 Vodafone Mobile NZ Limited, Annual Report 2007
