Debt at core of Chorus's fiscal fragility

CHALKIE
Last updated 05:00 04/12/2013

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OPINION: Finance is a luxurious vocation. If a physicist says "Behold, I have concluded that stone floats", his hypothesis would not last a few minutes at the beach. If a financier says an infrastructure asset should be valued at whatever it costs to build a new one, you can throw as many rocks as you like and it will dimple the smooth surface of his conviction not a jot.

This naturally leads to arguments about, say, how much a network company can charge for access to its copper wires.

Chalkie can't say what the correct price should be, but he can say that some of the arguments about it are guff.

The current debate involves whether Chorus should be able to charge as much for its old copper network as it does for its new fibre one. A common view in financial circles is that the price of copper should be based on its replacement cost, and its replacement cost is about the same as the cost of fibre, so the price should be the same as fibre.

Let Chalkie cast the first stone.

Suppose you had a ferry plying Cook Strait. It's 20 years old and showing its age. It is slow, uncomfortable and becoming prone to mechanical failure. Recognising the service isn't up to scratch, another ferry company enters the market with a new ship - a faster, more comfortable one with entertainment facilities.

The old ferry company argues that its ferry is worth the same as the new one, because that's how much it would cost to replace it.

So it charges the same price - and quickly goes out of business. Clearly, it is nonsense to say the old ferry can be valued at the cost of replacement, or that customers would be willing to pay the same price for the old and new services.

Yet this is exactly what some people seem to think is plausible in the wholesale broadband market.

Presumably they also think there are elves at the bottom of the garden and if you make a wish upon a star, the government will give you money.

Some of the people most confused about this issue seem to be investors in Chorus, who are riled that regulatory action has roughed up their supposedly smoothly profitable path.

Chalkie reckons they simply did not understand what they were getting into.

At its heart, the current problem of fibre versus copper broadband is about whether one should replace the other, or whether they should co-exist in competition for a while.

You could argue that it would be best if fibre simply replaced copper, like digital TV has replaced analogue, but anyone who was expecting that to happen here was not keeping their eyes on the road.

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Chorus, which won a government contract to build fibre in 24 out of 33 areas, expected its copper networks would compete with fibre in the nine areas run by other companies. That much is obvious from its demerger document in September 2011.

It is still obvious in the Government's discussion document issued in August, which said: "Chorus can set wholesale prices below the regulated price cap to match competition from fibre in those [nine] areas, if necessary to compete effectively with the [local fibre companies]."

The demerger document also explicitly notes the risks of fibre/copper interaction: "There is a risk that the regulator will set prices that do not provide New Chorus with an adequate return on its assets.

"In addition, if the prices that the regulator sets for copper-based products and services are significantly below the prices for comparable fibre-based services, fibre uptake may be negatively affected."

And so it came to pass. You can't say Chorus didn't try to warn everyone.

Chorus's assets, incidentally, are mainly short distance urban lines connecting homes and businesses to telephone exchanges - the fibre backbones in our long skinny country are owned by the likes of Telecom and Vodafone.

Anyway, the main gripe is the Commerce Commission's move to cut the price of unbundled bitstream access, or UBA, from $21.46 to $10.42 a month, from next December.

This meant copper wholesale broadband would thereafter cost from $34.44 a month, rising to $38.37 for the fanciest version.

That's a cut from the previous cost structure of $44.98 and Chorus estimated it would reduce its operating profit by $142m a year, or about 21 per cent.

In addition, it would seriously threaten its ability to pay for the installation of fibre as required by the government contract.

The uncertainty means Chorus's proposed 2014 dividend of 25.5c a share now looks unlikely unless circumstances change.

Investors are outraged and the share price has plummeted to below $1.50 from $3 in early August.

One particularly foaming fund manager told Chalkie the combination of regulatory and government behaviour was "theft".

The Government has now hired Ernst & Young to probe the veracity of Chorus's claims and it will be interesting to see what the accountancy firm concludes.

Chalkie reckons it may well discuss Chorus's debt, which is surely a major factor in its financial fragility.

In June 2011, when Telecom still owned Chorus, the group had debt of about $2.1 billion.

After separation, at June 2012 Chorus had debt of $1.609b.

By the same date, Telecom had debt of $1.01b. So the separated entities had a collective $2.6b of debt in June 2012, about $500 million more than they had as part of the same group a year earlier.

Chalkie can't help wondering whether extra debt was heaped on Chorus as part of the separation, in the expectation that it had nice stable cash flows from its infrastructure assets.

Certainly, the company was highly geared with equity of just $527m from total assets of $2.9b in 2012. Its gearing was similar this year - about 73 per cent on a debt to debt plus equity basis. That's high, but Chorus had the income to handle it and pay handsome dividends, if its copper cashflows kept coming in.

So, if things are looking a little tight for Chorus it could well be at least partly because the company just has too much debt. That would not be the fault of the regulator or the Government.

It appears that there are now a couple of scenarios. One is that the Government and Chorus get together and vary the terms of their contract so that Chorus doesn't get too stretched.

Another is that the full-on copper pricing review now under way, or the High Court appeal of the commission's decision, eventually comes up with a number that raises prices back to the level Chorus wants.

Chalkie reckons the latter is implausible without believing several impossible things before breakfast.

While the events so far have been a rocky road for investors and don't reflect well on the Government's planning, Chalkie reckons Chorus's problem is that the financial community chose to luxuriate in misconception rather than confront the real issues. Not that the financial community would ever admit it.

- Chalkie is written by Fairfax business bureau deputy editor Tim Hunter.

- BusinessDay

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