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Forsyth Barr

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New Zealand Professional Investment Services Firm, Forsyth Barr

Equity Bottom-Up

<h2>Chorus<br>Another Piece in&nbsp;the Regulatory Puzzle</h2>
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<p><strong>OUTPERFORM</strong></p>
<p>Chorus (CNU) recently provided (for the first time)&nbsp;opex&nbsp;and&nbsp;capex&nbsp;estimates&nbsp;that feed into the (work-in-progress) regulatory framework for its&nbsp;ultrafast&nbsp;fibre broadband (UFB) network. These are initial estimates only and&nbsp;precedents do highlight the Commerce Commission (CC) may not fully accept&nbsp;CNU's&nbsp;proposals. It is, however, favourable relative to our assumptions, reducing the risk of a material divergence vs. our medium-term forecasts. Step-by-step, the UFB regulatory process is edging toward completion expected in 3Q/4Q 2021. Conclusion should provide clarity of&nbsp;strong free cash flow (we forecast a 7–8% FCF yield) funding&nbsp;a substantial lift in dividend once the&nbsp;UFB network&nbsp;is complete. Maintain OUTPERFORM. &nbsp;</p>
<figure class="editor-figure mceNonEditable"><img src="https://static-prod.smartkarma.com/images/media/000/179/586/original/image_68480614331608508508422.png?1608508511" class="editor-image img-responsive" data-smartkarma-image-id="179586"></figure>
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<h3>Higher fibre&nbsp;opex&nbsp;positive; more&nbsp;capex&nbsp;may impact timing of dividend</h3>
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<p>All-else-equal, the greater the weighting of&nbsp;CNU's&nbsp;costs allocated to the regulatory bucket, the higher the revenue and profits the company is able to earn.</p>
<p>Positively,&nbsp;CNU's&nbsp;proposed UFB&nbsp;opex&nbsp;weighting&nbsp;is higher than our assumptions (albeit the gap narrows&nbsp;over time). Precedents do highlight the CC&nbsp;may not fully accept&nbsp;CNU's&nbsp;proposal, and we have not revised our forecasts at this time, however, it does (1) reduce the risk of a material variance vs. our expectation, and (2) represent upside risk to the&nbsp;financial loss asset&nbsp;(i.e. the losses on the fibre network prior to the first regulatory period commencing 1 January 2022) which will be included in&nbsp;CNU's&nbsp;initial regulatory asset base.</p>
<p>CNU's total fibre capex ​​​​​​​(as opposed to weighting) was also higher than our forecasts. Fibre capex's impact on CNU's valuation is minimal, but does influence cash flow timing — higher spend should translate to higher allowable fibre earnings longer-term. It is also questionable whether it will all materialise. The largest portion of fibre capex is new installations for which CNU has proposed a "wash-up mechanism" to reflect the inherent uncertainty in this forecast. Whilst higher fibre capex would not materially impact our valuation, it would reduce medium-term FCF and potentially influence the dividend.&nbsp;</p>
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<h3>Edging toward regulatory clarity</h3>
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<p>The market continues to look forward and consider&nbsp;the potential significant&nbsp;FCF&nbsp;CNU&nbsp;will generate, and implications for the dividend, once its fibre network is complete in 2022.&nbsp;CNU&nbsp;has previously explicitly outlined it will transition to a&nbsp;FCF-based dividend policy from FY22. Higher&nbsp;capex&nbsp;would lower the available&nbsp;FCF, however, it would not impact our view of a&nbsp;NZ50–60cps sustainable dividend longer-term.</p>
<p>CNU remains a long-dated business with substantial operating and financial leverage, and therefore, any assessment of the company’s fundamental value can vary materially depending on the UFB regulatory framework and, ultimately, on the maximum allowable revenue (MAR) its UFB network is able to earn. All-else-equal CNU's announcement today is a net positive step. Implementing the regime has been a very long process. The end is in sight, with a final decision scheduled in 3Q/4Q CY21.</p>
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<div><strong>Matt Henry CFA</strong></div>
<div><a href="mailto:matthew.henry@forsythbarr.co.nz" target="_blank" rel="noopener">matthew.henry@forsythbarr.co.<wbr>nz</a></div>
<div>+64 9 368 0115</div>
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Chorus Another Piece in&nbsp;the Regulatory Puzzle

OUTPERFORM
Chorus (CNU) recently provided (for the first time)&nbsp;opex&nbsp;and&nbsp;capex&nbsp;estimates&nbsp;that feed into the (work-in-progress) regulatory framework for its&nbsp;ultrafast&nbsp;fibre broadband (UFB) network. These are initial estimates only and&nbsp;precedents do highlight the Commerce Commission (CC) may not fully accept&nbsp;CNU's&nbsp;proposals. It is, however, favourable relative to our assumptions, reducing the risk of a material divergence vs. our medium-term forecasts. Step-by-step, the UFB regulatory process is edging toward completion expected in 3Q/4Q 2021. Conclusion should provide clarity of&nbsp;strong free cash flow (we forecast a 7–8% FCF yield) funding&nbsp;a substantial lift in dividend once the&nbsp;UFB network&nbsp;is complete. Maintain OUTPERFORM. &nbsp;


Higher fibre&nbsp;opex&nbsp;positive; more&nbsp;capex&nbsp;may impact timing of dividend


All-else-equal, the greater the weighting of&nbsp;CNU's&nbsp;costs allocated to the regulatory bucket, the higher the revenue and profits the company is able to earn.
Positively,&nbsp;CNU's&nbsp;proposed UFB&nbsp;opex&nbsp;weighting&nbsp;is higher than our assumptions (albeit the gap narrows&nbsp;over time). Precedents do highlight the CC&nbsp;may not fully accept&nbsp;CNU's&nbsp;proposal, and we have not revised our forecasts at this time, however, it does (1) reduce the risk of a material variance vs. our expectation, and (2) represent upside risk to the&nbsp;financial loss asset&nbsp;(i.e. the losses on the fibre network prior to the first regulatory period commencing 1 January 2022) which will be included in&nbsp;CNU's&nbsp;initial regulatory asset base.
CNU's total fibre capex ​​​​​​​(as opposed to weighting) was also higher than our forecasts. Fibre capex's impact on CNU's valuation is minimal, but does influence cash flow timing — higher spend should translate to higher allowable fibre earnings longer-term. It is also questionable whether it will all materialise. The largest portion of fibre capex is new installations for which CNU has proposed a "wash-up mechanism" to reflect the inherent uncertainty in this forecast. Whilst higher fibre capex would not materially impact our valuation, it would reduce medium-term FCF and potentially influence the dividend.&nbsp;


Edging toward regulatory clarity


The market continues to look forward and consider&nbsp;the potential significant&nbsp;FCF&nbsp;CNU&nbsp;will generate, and implications for the dividend, once its fibre network is complete in 2022.&nbsp;CNU&nbsp;has previously explicitly outlined it will transition to a&nbsp;FCF-based dividend policy from FY22. Higher&nbsp;capex&nbsp;would lower the available&nbsp;FCF, however, it would not impact our view of a&nbsp;NZ50–60cps sustainable dividend longer-term.
CNU remains a long-dated business with substantial operating and financial leverage, and therefore, any assessment of the company’s fundamental value can vary materially depending on the UFB regulatory framework and, ultimately, on the maximum allowable revenue (MAR) its UFB network is able to earn. All-else-equal CNU's announcement today is a net positive step. Implementing the regime has been a very long process. The end is in sight, with a final decision scheduled in 3Q/4Q CY21.




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




Chorus: Another Piece in the Regulatory Puzzle

Chorus Ltd

Chorus: Another Piece in the Regulatory Puzzle