The Haskell hearings uncovered a myriad of opinions concerning our industry, the risks, performance and future prospects. It is healthy to summarize them, evaluate them, and assess their impact upon future ski area development. While the environmental question is still a hot topic, it is my observation that the cost of capital will soon be recognized as the major deterrent to expansion and new development.
In preparing figures for Senator Haskell’s committee (about which there will be more later in this article) we used a figure of 24.2 per cent (before tax) as the current cost of capital, resulting from combination of borrowed funds equity. This extremely expensive cost for ski area development capital, we believe, reflects the financial community’s current perception of the risks, plus the widely discussed capital formation shortage. Money is a commodity just like steel and lumber, and a shortage of money will drive the price up.
Two excellent current examples are the recent sales of ski resort securities in Colorado. Copper Mountain sold $500,000 worth of Sub-ordinated Debentures for 9 per cent plus one lifetime ski pass for each $4,000 investment unit. Vail Associates, Inc. raised $3,000,000 through a Town of Vail, Sports Facilities Revenue Bond issue, sold at 9½ per cent Tax exempt. (Roughly 19 per cent before tax for high bracket purchasers.)
A prime example of the perceptions we must live with is an article in the New York Times, dated February 21, 1976 and headlined “Ski Resort Boom is Over Despite Crowds in Rockies.” The article was mainly concerned with the poor sales of resort condominiums and did not speak to ski area earnings or profits. However, in the eyes of the financial community, the risks are all lumped under “Ski Resorts.”
This particular article focused upon the financial problems of the newest ski resorts; Big Sky, Park City, Telluride, Copper Mt., and Snowbird. What manner of headline could have been developed by focusing upon the financial results of the 37 “top profit ski resorts” who earned an average 40.3 per cent before tax profit on equity, and a 21.1 per cent operating profit on Gross Fixed Assets? (Economic Analysis of North American Ski Areas — 1974-75).
Ski areas are typically perceived as risky business. They are subject to the normal risks of any business catering to the non-essential, leisure-time needs of the changing public. In addition, skiing is highly subject to the vagaries of weather. The seasonal nature of the business — meaning revenues are generated over no more than a 6 month period, while expenses run year round — creates yet a third risk factor. A fourth risk involves those areas operating on public lands with cancellable leases. (While the record shows no ski area investment losses due to permit cancellation, to the investment banker the threat is an additional risk.)
These risks can all be statistically evaluated, and adequate allowances provided in the financial projections. However, the fact is that the financial community views ski area financing as “high risk.” Historically, the typical sources of long term funding — the insurance companies, pension funds and the public equity markets — have not found ski areas as viable investments. The financial performance of the industry has not justified its perceived risks. In the past, ski areas have been financed by sentimentalists, skiers, local boosters and commercial banks with personal guarantees supporting the loans. Many are currently recreational divisions of business conglomerates; and many, recreational areas of land development companies.
The ski area industry reports five year return on equity of 8.0 per cent and returns to total capital of 6.0 per cent. These figures contrast with leisure industry earnings of 13.0 per cent on equity and 9.8 per cent on total capital. (See Ski Area Management, Winter 1976, “1974-75 Economic Survey”. P. 38). Ski areas with their higher risk must exceed leisure industry performance to begin to attract capital. The 1975 ski industry performance at 11.4 per cent return on equity, approaches the 1975 leisure industry return of 12.5 per cent. It appears from this discussion that equity investors would seek at least 15 per cent after tax to consider a ski area investment.
Ski areas are capital intensive businesses and typically financed with several layers of various debt and equity capital. Initial risk capital provides the seed money, while long term funding takes the form of limited partnership shares and/or subordinated debentures. Commercial term loans top off the package with mortgage money and working capital funds. The typical package might be 30 per cent equity, 30 per cent subordinated debentures and 40 per cent term and revolving loans.
The cost of the debt capital is generally expressed as X points above “prime” to reflect the risk and possibly the management burden anticipated. Debt capital is generally secured by a mortgage on the ski area’s assets, and further protected by the equity investment. These risk-minimizing, legal requirements affect the premium required to obtain term loan commitments. This premium will vary depending upon the proportion of equity protection, and the quality and record of the management team. The combined premium for risk and burden of management should fall between 1 and 4 points.
Subordinated Debentures are a form of equity with the protection of debt instruments and the tax adventages of an interest deduction. Ski area debentures typically require a sweetener in the form of ski lift privileges and/or convertible clauses. The cost of these funds will lie between pure debt and equity since the risks are also somewhere in-between.
Determining the cost of equity is a more complex concept. Equity investors typically start with a basic requirement, generally the current long term return potential of 30 year government bonds, (8.0 per cent before tax) and add points to reflect their perception of the risks.
Table I is my current perception of how the financial community views ski area risks. The minimum side reflects the probable cost for expansion capital by established ski areas with a good track record and proven management. The maximum side represents the probable risk premiums required to launch a new venture.
| Minimum | Maximum | ||
|---|---|---|---|
| 1. Pure Debt Capital (Before Tax) | |||
| A. Projected, average, Prime Rate | 8.5% | 8.5% | |
| B. Risk Premiums | 1.0% | 2.0% | |
| C. Management Burden | -0- | 2.0% | |
| Total | 9.5% | 12.5% | |
| 2. Subordinated Debt Capital (Before Tax) | |||
| A. Pure Debt Total | 9.5% | 12.5% | |
| B. Risk Premium and Sweetner | 2.0% | 7.0% | |
| Total | 11.5% | 19.5% | |
| 3. Equity Capital (After Tax) | |||
| A. After Tax Safe Rate | 4.0% | 4.0% | |
| B. Safety of Principal | 1.0% | 3.0% | |
| C. Certainity of Income Projection | 1.0% | 3.0% | |
| D. Reliability of Expense Projection | 1.0% | 3.0% | |
| E. Expense/Income Radio | 3.0% | 3.0% | |
| F. Marketability | -0- | 3.0% | |
| G. Acceptable as Collatoral | -0- | 3.0% | |
| H. Management Burden | -0- | 3.0% | |
| Total | 10.0% | 25.0% | |
| Before Tax Total— | 19.2% | 48.1% | |
| —(Based on 48% tax rate) | |||
| Average Cost of Capital | |||
| 1. Pure Debt | at 60% | 3.8% | 5.0% |
| 2. Pure Debt | at 40% | 3.45% | 5.85% |
| 3. Equity | at 30% | 5.76% | 14.43% |
| Total | 13.14% | 25.28% | |
| Plus: Recapture | 5.0 | 5.0 | |
| 18.14% | 30.28% |
Obviously the effect of income taxes is high, and any tax minimizing plan must be thoroughly evaluated. Vail’s use of a tax exempt revenue bond may be an important aspect of future ski area financing. Note here that equity capital with expectations of 10.0 per cent to 25.0 per cent after tax returns require 19.2 per cent to 48.1 per cent before tax yields!
Items B thru H are quality attributes and subjective measure of risk. These elements are used by professional appraisers as they seek to establish judgments of how the financial community will view the risk. While actual market rates determined by relating sales prices to net cash flows is the preferred method of determining cost of capital, ski area sales are so infrequent and individual as to effectively eliminate this source of data. The objective of such a mathematical exercise is to approximate the probable thought process of the typical investor as he evaluates competing investment opportunities. Of course each investor will look at opportunities slightly differently and most probably not as structured and deliberate as such a list might indicate. Glamour and emotion play a role in investment and these elements defy logic.
Most elements are self-evident, though item E requires some explanation. Projects (investment opportunities) requiring heavy operating expenses in relation to revenues, have a greater risk because small changes in revenue and expense can have a major effect upon the operating profits and the potential return to capital. Profitable ski areas typically require 70 per cent to 85 per cent of gross revenues to cover operating expenses, thus the expense/income ratio risk is high, as opposed to, say, an apartment building.
The final element in the cost of capital is an allowance for recapture of the investment. This recapture should logically occur during the life of the investment and is thus calculated at 5 per cent annually, meaning complete recapture in 20 years. This rate is reasonable since the majority of ski area assets are substantial lifts, buildings, utilities and earth shaping (roads, trails and parking lots) structures that will still be basically sound and operational at the end of 20 years.
What does this exercise mean? It means that 1) Ski area expansion capital is scarce and very hard to obtain; 2) That any new capital will be expensive; and thus, 3) That most new ski area projects will not prove economically feasible because of such high rates. This judgment comes at a time when demand continues to grow at some 10 per cent to 20 per cent annually and when ski area profits are also growing. It is, in short, a contradiction, and therefore logically has room for favorable change. However, unless change does in fact occur, ski lift prices cannot come down and most probably will have to increase.
I suspect also that the ski resort industry will see much innovation in financing, such as the revenue bond concept used by Vail.
One of the questions raised by Senator Haskell was what the cost of a lift ticket might be at a “no-frills” ski area. NSAA and ASAC (Association of Ski Area Consultants) undertook to research the feasibility of such a low-cost “Volkswagen” area that would hopefully provide an equivalently low-cost skiing experience for the consumer currently “priced out of the skiing market.” The report from ASAC was submitted to Senator Haskell on December 30.
To summarize our findings, with today’s costs it will take $833 per skier of capacity to build a Spartan, safe and sanitary ski area, utilizing the least expensive cable-surface lifts, and a design concept that maximizes skier density, minimizes average VTF/hr. per skier and minimizes the size of the base lodge. Our hypothetical prototype area was designed to support crowds of 1,800 skiers at one time, and budgeted at $1,500. Such an area, located where there is an operating season of 130 days, will require a $7.00 adult weekend all-day ticket if it is to be economically viable.
This prototype ski area requires 92,000 skier-visits to break even (39.3 per cent of capacity), and 152,000 skier-visits (65.0 per cent of capacity) to earn a reasonable return. The ski area consultants doubt that such a Spartan ski area could attract sufficient skier-visits to reach break-even.
Another way of looking at the effect of the cost of capital on ski lift ticket pricing, and on the current economics of the ski area development, is to note that 60 per cent of the gross revenue required to justify today’s hypothetical “Volkswagen” ski area is needed to cover interest, profit and income taxes, at the risk rate required to be competitive. This contrasts vividly with the existing industry situation where interest, profit and income taxes are only 25.7 per cent of gross revenue. Even the top half of the profitable ski areas report interest, profit and income taxes of 36.3 per cent of revenues.
Is there anything that can be done? One area where the industry can take an active role is to undertake activities to decrease the risks, and the investor’s perception of risks. I can see four specific areas that will help, and I am sure that there are more.
First is a public relations effort designed to achieve favorable stories as opposed to the New York Times article. Such a campaign should be addressed to the perceived risks and the current state of our industry in minimizing these risks. It should seek to change historic beliefs such as the old assumption that ski areas are no-profit amenities to attract people to real estate projects.
Second is a continued stepped up lobbying effort to remove the legal restrictions on USFS land leases, negotiate adequate compensation clauses if leases are cancelled, and to eliminate the threat of more government control. These risks are absolutely unnecessary and their removal will be a major step in bringing down the cost of capital.
Third is to continue and expand the Economic Study of North American Ski Areas. This factual analysis of financial performance should become the “bible” for potential investors. It should contain more detail and speak directly to the risks. For instance, seasonality is not a ski area risk, but rather related to the business of providing lodging.
Fourth is to embark upon nationwide skier market research, designed to obtain not only socio-economic and marketing data, but mainly to statistically measure the size, and growth potential of the future skier market. If, as some of us believe, there is a tremendous untapped skier potential, such a finding, adequately documented, will substantially decrease the risks.
While the cost of capital for ski area development is currently very expensive, the problem is not ours alone. Many other industries are also suffering the same shortage and paying historically high rates. This situation will be with us until new capital formation again outpaces demand. In the meantime, the ski industry should take action that may convince the financial community to downgrade their assessment of the risks associated with the ski industry.
