A broker's view on Chorus

16:00, Dec 20 2013

A Broker's View: Chorus Limited
Sector: Telecommunications

Overview: Investors in Chorus have been singing the blues since December 2012 when, with the share price at $3.40, a series of Commerce Commission decisions from that date regarding pricing reviews ultimately required them to drop the price they charge internet providers by 50 per cent.

In between the initial draft and final decisions, investors were given hope of government intervention, before political interference removed legislative change as an option to correct what is in our view flawed pricing methodology. Eventually the share price hit a low of $1.275 due to a large overseas fund exiting its holding, describing New Zealand's regulatory regime as making us as risky as Pakistan.

There have since been small gains since as a result of support from New Zealand institutions that see potential for a recovery in the stock once the Final Pricing Principle (FPP) adjusts the copper price to the actual cost of providing the service.

Pros: The FPP is the key to Chorus' future as a company as the copper price will be based on the replacement cost of Chorus' current copper network rather a theoretical price benchmarked against what a vertically integrated Swedish Telco is allowed for its own network.

The ComCom considered 31 countries to benchmark against, but ultimately had to settle to merely using Sweden as its proxy. Even if Sweden was the most appropriate proxy, a deeper analysis of that choice (which was subjective) throws up numerous red flags that show the international benchmarking process was in our view clearly inaccurate, given New Zealand's unique geography, population spread, and housing stock.

For example firstly, and most glaringly, there would be a big disparity in the costs of providing the services in the two countries. The most obvious illustration of why that is the way people live in each country. In Sweden at least 55 per cent of the population are living in multi-family dwellings (apartments, row houses etc.).

Compare that to New Zealand where in excess of 80 per cent of us live in stand alone dwellings.  Even blind freddy would realise this create a big difference in the cost of providing a network in the two countries.

Secondly, the exchange rate used was NZ$5.99 for every Swedish Krona. This is higher than the NZD has ever traded against the Krona. The 10 year average is closer to NZ$5, a marked difference that would push the copper price up 17 per cent.

Thirdly, the price point picked in Sweden was their lowest speed available. Higher speeds generally incur higher costs and as Chorus currently provide copper broadband at speeds far higher than that chosen by the ComCom an argument could easily be made that the ComCom set the bar too low. This has lead to speculation that services could suffer under the current regime and speeds could likely reduce as a result.

Technically, Chorus are only required by law to provide speeds of 32kb/s at 99.9 percent probability over a 15 minute period (this is essentially dialup speed). Hopefully a return to the dark ages of internet connections can be avoided, but at the end of the day, you get what you pay for.

The key message from all of this is that the regulated copper price will change again once the FPP is calculated. The FPP will be based on Total Service Long Run Incremental Cost, which is essentially the cost of replacing the existing network, adjusted to be a Modern Equivalent Asset.

The current ComCom prices imply a value of Chorus' network of under $3b, whereas previous estimates (when Chorus was part of Telecom) by the ComCom have valued the network at as much as $10b. The truth is most likely somewhere in the middle.

Given that Chorus is spending over $3b to build the Ultrafast Fibre Network (UFB) to 56 per cent of easier to reach parts of NZ, and that much of the cost of building the network comes from trenching (which is a major component of the cost of a network) we can assume that to replace the entire country's copper network would cost far more than the current implied ComCom valuation.

Cons: Chorus noted that there will be a $1b shortfall funding the UFB rollout if the proposed copper prices are held. A recent independent review by Ernst and Young confirmed this figure but also came up with ways to decrease the shortfall to an estimated $200-$250. This includes the expected changes to the dividend policy and $400-$500m from "revenue uplift, operating and capital expenditure saving initiatives". The Government has instructed Chorus to begin discussions with Crown Fibre Holdings, their partner in the UFB Public/Private Partnership, to find ways to address the funding gap.

The major concern for the company will be debt covenants. In December next year, assuming the FPP process has not been completed, the lower copper prices will be introduced. This will reduce Chorus' Earnings before Interest, Tax, Depreciation and Amortisation (EBITDA) by a reported $142m. Chorus are required to keep net debt to below 3.75 times EBITDA and will likely exceed this level under the new pricing regime. This may then require Chorus to raise capital, seek debt assurances from the government or covenant waivers from the debt holders.

Which of these scenarios plays out will have a large bearing on investor returns. Given the likelihood that the FPP will see a return to a reasonable return on assets for the company, it is quite possible that debt holders will grant such a waiver or the government will guarantee their debt until the conclusion of the FPP process. If that is not the case then Chorus investors face the prospect of having to raise funds to get their net debt levels back within covenant levels.

Dividends will be severely truncated for the foreseeable future. There is also the fact that Chorus are $300m over budget on their leg of the UFB rollout thus far as resource consenting issues add to headaches.

The UFB rollout is apparently not at risk due to these recent decisions, but Chorus have filed a High Court appeal to determine whether the ComCom has applied the law correctly. They are questioning the interpretation of Section 18(2A) in relation to the UFB rollout as it requires the ComCom to consider the incentives and risks facing investors in major new telecommunications infrastructure. The decision is likely to come before the FPP is completed so could give shareholders earlier relief. Chorus are also in discussions with Retail Service Providers to find a way to resolve the pricing issue.

Price performance: Chorus shares are off 58 per cent since the original draft UBA decision, recently trading at $1.42.

Investment outlook: No longer suitable for income investors. However, those prepared to wait it out could see capital gains. Not a stock for the faint of heart given the regulatory environment. The stock has become a political football, which would increase volatility in election year.

Final Thought: Claims that Chorus are making excessive profits are wide of the mark and the data has often been skewed by parties who would gain from the price cut being permanent. An internationally accepted measure for fair returns for monopoly businesses is an average return on assets (ROA) of between 6 and 8 per cent. In the most recent 2013 financial year Chorus had an average ROA of 7.9 per cent. Whilst at the top end of this range, the return is likely to decrease as they build the currently underutilised UFB network.

Claims have also been made of excessive dividends. Chorus paid $99 million in dividends in 2013 on Net Profit after Tax of $171 million, a payout ratio 58 per cent, which is well below most listed infrastructure providers. The reason the payout was so low is the huge amount of capital expenditure Chorus are currently spending on the UFB network. Capital expenditure was $681 million in 2013, 10 per cent of which went on maintaining the copper network.

Return on Equity (ROE) has also been used to show "excessive" returns, however this is not relevant to the discussion because the figure is merely a function of the amount of debt on the balance sheet, which has nothing to do with whether they getting excessive return on their copper network.

*A Broker's View is written by James Smalley & Grant Davies, Advisors at Hamilton Hindin Greene Limited. This article represents general information provided by Hamilton Hindin Greene, who may hold an interest in the security. It does not constitute investment advice. Disclosure documents are available by request and free of charge through www.hhg.co.nz.


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