QUALIPORT
The Myth Of The Unregulated Franchise

By Maynard Paton (TMFMayn)
December 8, 2003

According to Warren Buffett, a 'franchise' is defined as a company providing a product or service that (1) is needed or desired, (2) has no close substitute, and (3) is not regulated.

Point (1) is straightforward enough, though point (2) can be somewhat trickier to determine. But finding firms matching point (3) is fast becoming almost impossible. A statement last month from the Office of Fair Trading (OFT) suggests Buffett's 'unregulated franchise' is in fact a bit of a myth.

The statement in question concerned Qualiport member London Stock Exchange (LSE: LSE) and the 'significant increase' the company applied to its listing fees in April 2002. The OFT investigated the increase and the Exchange eventually agreed to the undertakings (and therefore avoided a 'significant adverse affect on competition' ruling and a deeper Competition Commission probe).

The OFT's remedies involved a reduction of more than 25% to the Exchange's listing fees for 2004/2005, with subsequent increases limited to general wage inflation until a 2007 review. According to the OFT, the Exchange had originally lifted its listing levies by around 85%. 

The cost to the Exchange of the OFT's proposals will be £6m of lost revenues. With an annual turnover of over £220m, the damage is not that great in the wider scheme of things. However, the OFT's message to investors is clear: companies that have no formal pricing regulator (like the London Stock Exchange) can still have their charging powers limited. So much for Buffett's 'unregulated franchise'.

Regulated businesses

With the OFT able to limit the pricing power of 'unregulated' companies, the obvious question now for franchise investors such as the Qualiport is whether traditional, regulated businesses can be considered as quality, long-term investments? Candidates could include airport owner BAA (LSE: BAA), electricity supplier National Grid Transco (LSE: NGT), phone firm BT (LSE: BT.A) and water group Severn Trent (LSE: SVT), which are regulated by the CAA, OFGEM, OFTEL and OFWAT respectively.

The main factors to consider with these types of businesses are:

• Multi-year agreements: Regulatory pricing caps are defined in multi-year agreements, often in a 'inflation plus/less x%' format. 
• Expenses: Other areas, such as customer service, are monitored. As well as lower income, watchdogs can also demand greater expenditure to meet industry standards.
• In the public eye: Rising fuel bills for example can create a political storm and add pressure on regulators to act.

These more traditional, regulated businesses meet two key Qualiport criteria: they all have a sustainable competitive advantage (they wouldn't be regulated if they hadn't) and they all have predictable, repeat income. A value attraction is the generous dividend yields that tend to be on offer.

The negatives however may centre on large capital expenditure and low returns on equity. Huge amounts of cash could be ploughed into an electricity/gas/telephone/water network year after year, but a regulator may ensure customers -- and not shareholders -- see most of the benefit from the investment.

Watch list

Interestingly, Buffett himself has gradually become attracted to regulated business. In 1999, he spent $2b on a 76% stake in MidAmerican Energy, a US electricity group. Among the firm's subsidiaries are Northern Electric and Yorkshire Electric, which supply electricity to 3.6m British customers. When he bought MidAmerican, Buffett said: "Though there are many regulatory constraints in the utility industry, it's possible that we will make additional commitments in the field. If we do, the amounts involved could be large."

With their attractive business characteristics, there could be scope for companies regulated by a dedicated customer-focused watchdog to join the Qualiport's watch list. That is, of course, if they surpass the qualities possessed by the firms already on the list. At this stage though, it's fair to say dominant companies liable to just an occasional OFT/Competition Commission investigation could prove to be the more attractive investments. Still, buy and hold investors should always prefer a franchise that has to be restricted by an industry watchdog, to a business facing so much competition that the customers happily do the regulating.

The author owns shares in the London Stock Exchange.