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Forsyth Barr

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New Zealand Professional Investment Services Firm, Forsyth Barr

Equity Bottom-Up

<h2>Chorus</h2>
An Improved R<a target="_blank"></a>egulatory Picture
The regulatory picture for Chorus (CNU) improved with the Commerce Commission’s (CC) draft decision on the “input methodologies” which feed into the regulatory determination for CNU’s new ultrafast fibre broadband (UFB) network. From a CNU perspective, the draft decision is positive progress relative to the CC’s emerging views published in May. Whilst there remains an inherent and material uncertainty in the ultimate outcome from the UFB regulatory process, which will not be finalised until 2Q 2021, our base case scenario remains materially above what is currently implied by the share price. Maintain OUTPERFORM.
What’s changed?
<ul>
<li>Target Price: Lifted to NZ$6.40.</li>
</ul>
Positive changes vs. CC’s “emerging views”
The principal changes in the CC’s draft decision vs. the emerging views that benefit CNU are:
<ul>
<li>Asset beta: Increased to 0.49, from 0.46 (but below our assumed 0.51).</li>
<li>Market risk premium: Increased to 7.5%, from 7.0%.</li>
<li>Tax losses: The opening regulatory asset base (RAB) is to include the present value of pre-2022 losses. Tax losses are now able to be included in those loss calculations. Previously the CC’s view was to exclude tax losses based on the assumption that they had already been used to offset profits in other parts of the company.</li>
<li>Crown financing: The benefit of the Crown financing is to be deducted in the determination of the “maximum allowable revenue” (MAR) CNU is able to earn on the UFB. The CC now proposes to calculate this benefit at the (lower) cost of debt vs. previously at WACC.</li>
<li>Asset stranding (“type II”) risks: A +10bp margin on WACC to compensate for asset stranding risk.</li>
</ul>
With the exception of asset beta, we had factored no other improvements into our base case scenario. Incorporating the above changes increases our DCF valuation by +NZ65cps or +11%. We expect CNU will continue to challenge some assumptions, most notably asset beta, but believe achieving changes will be more difficult in the final stage of the input methodologies process.
Comfortable with uncertainty; remain attracted to long-term cash flow
We continue to acknowledge the inherently high margin of error in any CNU valuation given the possible range of regulatory outcomes, the long-dated nature of the UFB asset, and the company’s high operating and financial leverage. We remain comfortable with this uncertainty given: (1) our base case scenario valuation is significantly above the share price, and (2) the cost of capital we used to derive this valuation is significantly above what the market is currently applying to defensive assets. The CC’s current schedule is to finalise the input methodologies in June 2020, and the UFB’s MAR in 2Q 2021.&nbsp;
<div class="content-highlight">
Investment View
We remain attracted to CNU’s fundamental value underpinned by the considerable long-term free cash flow we expect the company to generate once its fibre network is complete in 2022.&nbsp;OUTPERFORM.&nbsp;
</div>
Matt Henry, CFA matt.henry@forsythbarr.co.nz +64 9 368 0115

Chorus
An Improved Regulatory Picture
The regulatory picture for Chorus (CNU) improved with the Commerce Commission’s (CC) draft decision on the “input methodologies” which feed into the regulatory determination for CNU’s new ultrafast fibre broadband (UFB) network. From a CNU perspective, the draft decision is positive progress relative to the CC’s emerging views published in May. Whilst there remains an inherent and material uncertainty in the ultimate outcome from the UFB regulatory process, which will not be finalised until 2Q 2021, our base case scenario remains materially above what is currently implied by the share price. Maintain OUTPERFORM.
What’s changed?

Target Price: Lifted to NZ$6.40.

Positive changes vs. CC’s “emerging views”
The principal changes in the CC’s draft decision vs. the emerging views that benefit CNU are:

Asset beta: Increased to 0.49, from 0.46 (but below our assumed 0.51).
Market risk premium: Increased to 7.5%, from 7.0%.
Tax losses: The opening regulatory asset base (RAB) is to include the present value of pre-2022 losses. Tax losses are now able to be included in those loss calculations. Previously the CC’s view was to exclude tax losses based on the assumption that they had already been used to offset profits in other parts of the company.
Crown financing: The benefit of the Crown financing is to be deducted in the determination of the “maximum allowable revenue” (MAR) CNU is able to earn on the UFB. The CC now proposes to calculate this benefit at the (lower) cost of debt vs. previously at WACC.
Asset stranding (“type II”) risks: A +10bp margin on WACC to compensate for asset stranding risk.

With the exception of asset beta, we had factored no other improvements into our base case scenario. Incorporating the above changes increases our DCF valuation by +NZ65cps or +11%. We expect CNU will continue to challenge some assumptions, most notably asset beta, but believe achieving changes will be more difficult in the final stage of the input methodologies process.
Comfortable with uncertainty; remain attracted to long-term cash flow
We continue to acknowledge the inherently high margin of error in any CNU valuation given the possible range of regulatory outcomes, the long-dated nature of the UFB asset, and the company’s high operating and financial leverage. We remain comfortable with this uncertainty given: (1) our base case scenario valuation is significantly above the share price, and (2) the cost of capital we used to derive this valuation is significantly above what the market is currently applying to defensive assets. The CC’s current schedule is to finalise the input methodologies in June 2020, and the UFB’s MAR in 2Q 2021.&nbsp;

Investment View
We remain attracted to CNU’s fundamental value underpinned by the considerable long-term free cash flow we expect the company to generate once its fibre network is complete in 2022.&nbsp;OUTPERFORM.&nbsp;

Matt Henry, CFA matt.henry@forsythbarr.co.nz +64 9 368 0115

Chorus Ltd

Chorus: An Improved Regulatory Picture