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New Zealand Professional Investment Services Firm, Forsyth Barr

Equity Bottom-Up

<h2>Chorus Initial thoughts – Draft ComCom decision: Wins, losses and questions</h2>
The Commerce Commission (CC) has provided an initial draft view on Chorus’s (CNU) maximum allowable revenue (MAR) range for its ultrafast fibre broadband (UFB) network through the first three-year regulatory period starting 1 January 2022.
The CC’s assessment is a NZ$689-786m range over the period which is:
<ol>
<li>Consistent with our current fibre revenue forecast of NZ$674-785m (albeit the building blocks composition differs – lower opex broadly offset by higher depreciation of the financial loss asset).</li>
<li>Below CNU’s proposed MAR range of NZ$720-820m.</li>
</ol>
Still a few key steps to go
Whilst today’s CC announcement is somewhat helpful providing a confidence level around CNU’s MAR, there remain a number of uncertainties which could still influence the outcome:
<ul>
<li>The CC has yet to make draft decisions on (i) the value of CNU’s regulatory asset base (RAB), and (ii) methodologies for allocating CNU’s costs between the UFB network and the rest of its business.</li>
<li>The CC has lowered CNU’s proposed UFB opex by NZ$52m/11%, the bulk (NZ$43m) of which is based on highly subjective assumptions of efficiency gains including from proposed IT investment. We expect CNU to challenge these assumptions. (Or if they are achievable they represent upside risk to our forecasts.) The balance reflects a reduction in forecast fibre demand.</li>
<li>The CC has lowered CNU’s proposed base capex by NZ$107m/17%, however, the majority (NZ$71m) is where the CC has advised CNU should apply via specific capex proposals rather than including in the base allowance. This (or some of it) could therefore be added back. Again, the majority of the balance reflects a reduction in forecast demand.</li>
<li>CNU’s WACC and CPI (for asset revaluation) assumptions will be updated in June. Both are likely to be modestly higher vs. current assumptions given bond market movements and updated RBNZ forecasts.</li>
</ul>
In addition to the above there were a couple of other notable decisions in today’s CC release.
<ul>
<li>(As proposed by CNU) the CC has introduced a wash-up mechanism whereby any under/over recovery in revenue due to variances in demand (including capex impacts), Crown funding, or the final RAB determination, will be carried forward into future periods.&nbsp;</li>
<li>The CC has proposed to use a diminishing value (DV) depreciation method over 14 years for the financial loss asset (pre-2022 UFB losses). The DV approach (i) pulls forward returns, but is NPV-neutral i.e. higher cash received today is offset by less cash received in the future, and (ii) helps to smooth MAR over time.</li>
</ul>
Where does that leave us?
Supports base case of strong medium-term cash flow and dividend lift:&nbsp;The CC’s draft decision (including the adoption of the DV depreciation approach to the financial loss asset) enhances our confidence in CNU being able to deliver a strong lift in free cash flow (FCF) and dividend over the medium-term. The CC’s MAR range is consistent with our assumptions that flow through to forecast medium-term FCF of c.NZ60-70cps.
Risk to longer-term cash flow and valuation:&nbsp;A higher DV is beneficial in the near-term, but reduces returns in the long-term. For us the key uncertainty from today’s release is the medium to long-term opex for CNU and its UFB. Either (i) CNU convinces the CC its opex assumptions are realistic and they are included in the MAR (positive from here), (iii) CNU bears an unrecoverable cost (negative), and/or (iii) the CC’s efficiency assumptions are realistic and our opex assumptions will be revised lower (positive). Irrespective, the shutdown of CNU’s copper network over time will mean a greater proportion of its opex is allocated to the UFB&nbsp;network&nbsp;and recovered within the MAR.
Still uncertainty ahead:&nbsp;As discussed above, there is still scope for the CC’s draft to change. Given CNU is&nbsp;a long-dated business with substantial operating and financial leverage, any assessment of the company’s fundamental value, cash flow and dividends can still vary with seemingly modest variances in the outcome. The next steps in the process is the CC's draft decisions on CNU's RAB and cost allocation methodologies scheduled for August.
Matt Henry &nbsp;CFA Head of Wealth Management Research
<figure class="editor-figure mceNonEditable"><img src="https://mail.google.com/mail/u/0?ui=2&amp;ik=f57c39853c&amp;attid=0.1&amp;permmsgid=msg-f:1700869666652965187&amp;th=179ab3f342164943&amp;view=fimg&amp;sz=s0-l75-ft&amp;attbid=ANGjdJ9kTzGK1eaF5CSwT7fa6gsM3MmNXWgeNFA_1wI2ypoulKLY5JzY21MThvvRqXzCJubWWrr0pMI4ExL08J82XDtNxdjSR9XwJ683LlLTQE2HiNomEJ3GMkoVvhM&amp;disp=emb" class="editor-image img-responsive"></figure>
 M: +64 21 329 291 |P: +64 9 368 0115 | TF: 0800 367 227&nbsp; Level 23, Lumley Centre, 88 Shortland Street, Auckland

Chorus Initial thoughts – Draft ComCom decision: Wins, losses and questions
The Commerce Commission (CC) has provided an initial draft view on Chorus’s (CNU) maximum allowable revenue (MAR) range for its ultrafast fibre broadband (UFB) network through the first three-year regulatory period starting 1 January 2022.
The CC’s assessment is a NZ$689-786m range over the period which is:

Consistent with our current fibre revenue forecast of NZ$674-785m (albeit the building blocks composition differs – lower opex broadly offset by higher depreciation of the financial loss asset).
Below CNU’s proposed MAR range of NZ$720-820m.

Still a few key steps to go
Whilst today’s CC announcement is somewhat helpful providing a confidence level around CNU’s MAR, there remain a number of uncertainties which could still influence the outcome:

The CC has yet to make draft decisions on (i) the value of CNU’s regulatory asset base (RAB), and (ii) methodologies for allocating CNU’s costs between the UFB network and the rest of its business.
The CC has lowered CNU’s proposed UFB opex by NZ$52m/11%, the bulk (NZ$43m) of which is based on highly subjective assumptions of efficiency gains including from proposed IT investment. We expect CNU to challenge these assumptions. (Or if they are achievable they represent upside risk to our forecasts.) The balance reflects a reduction in forecast fibre demand.
The CC has lowered CNU’s proposed base capex by NZ$107m/17%, however, the majority (NZ$71m) is where the CC has advised CNU should apply via specific capex proposals rather than including in the base allowance. This (or some of it) could therefore be added back. Again, the majority of the balance reflects a reduction in forecast demand.
CNU’s WACC and CPI (for asset revaluation) assumptions will be updated in June. Both are likely to be modestly higher vs. current assumptions given bond market movements and updated RBNZ forecasts.

In addition to the above there were a couple of other notable decisions in today’s CC release.

(As proposed by CNU) the CC has introduced a wash-up mechanism whereby any under/over recovery in revenue due to variances in demand (including capex impacts), Crown funding, or the final RAB determination, will be carried forward into future periods.&nbsp;
The CC has proposed to use a diminishing value (DV) depreciation method over 14 years for the financial loss asset (pre-2022 UFB losses). The DV approach (i) pulls forward returns, but is NPV-neutral i.e. higher cash received today is offset by less cash received in the future, and (ii) helps to smooth MAR over time.

Where does that leave us?
Supports base case of strong medium-term cash flow and dividend lift:&nbsp;The CC’s draft decision (including the adoption of the DV depreciation approach to the financial loss asset) enhances our confidence in CNU being able to deliver a strong lift in free cash flow (FCF) and dividend over the medium-term. The CC’s MAR range is consistent with our assumptions that flow through to forecast medium-term FCF of c.NZ60-70cps.
Risk to longer-term cash flow and valuation:&nbsp;A higher DV is beneficial in the near-term, but reduces returns in the long-term. For us the key uncertainty from today’s release is the medium to long-term opex for CNU and its UFB. Either (i) CNU convinces the CC its opex assumptions are realistic and they are included in the MAR (positive from here), (iii) CNU bears an unrecoverable cost (negative), and/or (iii) the CC’s efficiency assumptions are realistic and our opex assumptions will be revised lower (positive). Irrespective, the shutdown of CNU’s copper network over time will mean a greater proportion of its opex is allocated to the UFB&nbsp;network&nbsp;and recovered within the MAR.
Still uncertainty ahead:&nbsp;As discussed above, there is still scope for the CC’s draft to change. Given CNU is&nbsp;a long-dated business with substantial operating and financial leverage, any assessment of the company’s fundamental value, cash flow and dividends can still vary with seemingly modest variances in the outcome. The next steps in the process is the CC's draft decisions on CNU's RAB and cost allocation methodologies scheduled for August.
Matt Henry &nbsp;CFA Head of Wealth Management Research

 M: +64 21 329 291 |P: +64 9 368 0115 | TF: 0800 367 227&nbsp; Level 23, Lumley Centre, 88 Shortland Street, Auckland

Chorus: Initial Thoughts – Draft ComCom Decision: Wins, Losses and Questions

Chorus Ltd

Chorus: Initial Thoughts – Draft ComCom Decision: Wins, Losses and Questions