New Payphone Economics – A Thoeretical Model

Posted: 04/1999

New Payphone Economics
A Theoretical Model
By John S. Bain

As with so many industries, the twin forces of technology and political mandate are
hard at work in the payphone service provider (PSP) industry, enabling a slow but sure
return to profitability. In particular, the competitive entrants, the independent payphone
providers (IPPs), will benefit greatly from recent developments, including terms in the
Telecom-munications Act of 1996 and the payphone orders issued by the Federal
Communications Com-mission (FCC). In part, the benefit will be financial as issues related
to compensation for dial-around–access code and subscriber 800–calls are addressed. More
important is the recognition of IPPs as a legitimate part of the PSP industry, and a clear
intent to move toward a level playing field in a market previously controlled by monopoly
phone companies.

To understand the changing economics of being an IPP, here is a theoretical financial
model of payphone operation wherein the results of recent regulations affect substantial
improvement in the bottom line.

Capital Investment

The capital investment per payphone will vary, depending on the nature of the phone
installed, the difficulty of the installation and any additional costs incurred in
securing the location contract (see Table 1, below). With regard to the phone, it is
helpful to note that the simplest payphones, often called "dumb" phones, are the
type generally used by local exchange carriers (LECs). Such phones have minimal internal
electronics, are entirely line-powered and rely on central office (CO) coin-line services
to provide calling features. By contrast, the sort of phones used by IPPs tend to be
"smart" phones, which have extensive internal electronics and software. Older
models tend to require commercial power, although all manufacturers now offer line-powered
models.

Table 1

In general the smart payphone itself will cost the operator approximately $1,000. Some
installation cost will be incurred, which can vary from simply putting the payphone in the
same location vacated by an earlier provider (typically the service LEC) to a complex
affair requiring pouring a concrete pad, running electric power to the location and
erecting a pedestal or other suitable enclosure. Additionally, there will be some sort of
up-front "bonus" or commission paid to the location owner.

The future trend in capital costs can be expected to decline somewhat when and if
economies of scale in the manufacturing of the electronics come into play. However, major
components of the phone, including the case, handset, dial pad, coin mechanism, pedestal
and pad are not particularly high-tech and are unlikely to see any major cost reductions.
What is more likely is that, as in the semiconductor industry generally, the function and
capabilities of the smart phones will continue to increase while prices remain relatively
constant.

Common sense indicates that the initial capital cost of an installed payphone should be
depreciated like any other capital asset: over the expected service life less salvage
value. In the case of a payphone, the service life is the life of the associated contract
with the location owner. Because most contracts are renewed when they expire, the
effective service life of an installed payphone is much greater than the nominal term of
the initial contract. The phones themselves–literally designed to be bulletproof–have
very long potential service lives. Some payphone route operators capitalize the entire
initial cost of the phone and amortize it over 10 years. Others amortize the hardware cost
over 10 years, but write off the intangibles (e.g. installation, agent fees, etc.) over
the life of the contract. However, all PSPs seem to expense maintenance capital
expenditures as incurred.

For purposes of this discussion, let’s look at depreciation through a typical contract
of three years. The salvage value, then, is the realizable value of the payphone at the
end of that three-year contract. The market value of a refurbished smart phone is about
$500, prompting us to assume a salvage value of $200. Using the capital figures in Table 1
as a guide, and assuming that everything but the phone itself goes to zero value at the
end of the contract, one can estimate the annual depreciation expense at ($2,000-$200)/3 =
$600 per year, or $50 per month.

For purposes of illustration, this example assumes that one-half of the initial cost of
the phone is financed with debt at an annual percentage rate (APR) of 12 percent. Monthly
interest expense, therefore, will be ($1,000)(0.12)/12 = $10 per phone.

It is possible to come up with an average payphone revenue profile. The proposition of
calling will, of course, vary radically from location to location. A telephone at a
supermarket or library will tend to generate almost entirely local calls, since not too
many people travel far from home to buy groceries or borrow books. One at an airport,
however, will be used much more for interexchange noncoin calling, since a large
proportion of potential users are a long way from their homes or offices. However, given
the average number of calls per phone per month (see Table 2, below), we can suggest a
typical revenue profile (see Table 3, below). Keep in mind that the revenue per call is
assumed to be net of uncollectibles. Alternatively, we could view the number of noncoin
calls shown as being those on which payment is made good.

Table 2

Table 3

Expenses

The relevant expense items have been estimated (see Table 4, below) based on the actual
experience of several publicly traded payphone companies, including ChoiceTel
Communications Inc., Plymouth, Minn; Davel Communications Group, Tampa, Fla., and Peoples
Telephone Company, Miami, which are in the process of merging; and PhoneTel Technologies
Inc., Cleveland.

Table 4

* Telephone line charges. Line charges essentially cover the IPP’s own telephone
bill, and include the basic monthly charge for a customer-owned coin operated telephone
(COCOT) or coin line (where tariffed), as well as local usage charges, if any. The amount
has been in the range of $45 per month for the publicly traded IPPs. Note, however, that a
general belief is that local access line rate will decline when alternatives for local
access develop in the market. We also suggest that a dollar of expense reduction is worth
more to the PSP than an additional dollar of revenue since no commission must be paid on
cost savings.

* Location owner commissions. Commissions to location owners are assumed at 20
percent of gross revenue. There is, of course, no rigid standard in the industry, and
commission contracts take a wide variety of forms, including minimum monthly guarantees,
commissions on coin calls only or no commissions on dial-around calling, for example.

* Field service and coin collection. Like it or not, payphones need frequent
physical attention from route technicians to collect the coins, make needed repairs and
clean the set and enclosure. In addition, the route technicians can keep in touch with the
location owners/managers to ensure that service is at a satisfactory level. This expense
has been running at an average rate of about $40 per phone per month.

* Billing and collection. Depending on the amount of direct call processing and
billing undertaken, monthly billing and collection costs can vary widely. We assume a
minimum amount of $5 per month per phone.

* Depreciation. As discussed earlier, depreciation works out to be about $50 per
phone per month.

* General and administrative. Corp-orate overhead tends to run about $30 per
phone per month.

* Interest expense. As outlined earlier, interest expense is assumed to be $10
per phone per month.

Net Income Contribution

Building on the revenue and expense items, we can estimate net income and earnings
before interest, taxes, depreciation and amortization (EBITDA) (see Table 5, below). The
improvement in financial performance due to the combination of deregulation of the local
coin rate and the provision of dial-around compensation at the 28.4-cent rate is
illustrated in Table 6 (below), which treats a single payphone as a discounted cash
flow/capital budgeting project. Continuing to use the assumption that the payphone can be
financed 50/50 with equity and borrowed funds, the project takes the following form: time
zero, a cash outlay of $1,000 for half the installation cost (the other half being
borrowed). Positive cash flow is shown for months one to 36, then negative cash flow of
$800 (the $1,000 debt repayment less the assumed $200 salvage value of the instrument) at
the end of the three-year time horizon.

Table 5

Table 6

John S. Bain is a CFA and analyst with Hoak Breedlove Wesneski & Co., Dallas. He
can be reached at +1 972 960 4846, or by e-mail at [email protected]