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Morningstar | Chorus Hits the High Note but Composition Still in Flux. See Updated Analyst Note from 02 Jul 2019

Shares in Chorus are trading at a premium of almost 40% to our NZD 4.10 (AUD 3.95) fair value estimates per share. The 35% stock price rally over the past year has certainly not been driven by any consensus estimate upgrades, which have been scarce during that time. Rather, it has been largely fuelled by the declining interest-rate environment, in New Zealand (at a record low 1.5%), Australia (at record-low 1.0%) and virtually every other developed economy. The consequent search for yield has been supplemented by Chorus' metamorphosis, at least in the eyes of investors, from a lower-multiple telecom entity to a higher-multiple infrastructure/utility one.

Chorus is trading at a forward enterprise value/EBITDA of 8.5, a re-rating that has driven it beyond the Australia and New Zealand telecom sector median of 8.4. The no- moat group's multiple is still lower than the Australia and New Zealand utility sector enterprise value/EBITDA median of 13.3, providing multiple arbitrage investors with ammunition to further bid up Chorus shares.

At current levels, however, there are downside risks. First, the regulatory framework for governing Chorus' fibre network is still not set. Critical parameters such as the cost of capital, asset valuation and cost allocation (used to determined Chorus' regulated asset base and the maximum allowable revenue/prices it can charge) are still subject to conjecture until November 2019 and beyond. Second, unlike utility entities, Chorus faces a potential structural challenger to its fixed-line infrastructure in the form of 5G (and however many more Gs after that) mobile technology in the long term. Granted, the sheer capacity and stability of the fibre being rolled out in New Zealand are superior to mobile, especially for the broadband-obsessed New Zealanders. But it would be dangerous to underestimate the wildcard potential of fixed-wireless to encroach on the fibre infrastructure over time.

And Chorus is still losing connections. In the most recent March quarter of 2019, it saw a decline of 14,000 lines. Seasonal factors mean this was less than the average quarterly loss of 18,000-plus over the past year. Further, much of this loss was in legacy copper connections (19,000), as Chorus registered a net 5,000 gain in broadband connections (12,000 gain in its ultra fast broadband areas offset by 7,000 loss in local fibre company areas). Nevertheless, connection losses are continuing, which is likely to result in EBITDA stabilising at belowNZD 640 million in fiscal 2020, before growth returns. We maintain our current five-year EBITDA CAGR forecast of 2.6%.

Our NZD 4.10 fair value estimate implies enterprise value/EBITDA of 6.5 and yield of 5.6%. We believe these metrics adequately balance the uncertainties (including a potential partial unwinding of the telecom/utility multiple arbitrage) against Chorus' stable earnings.

Circling back to the new fibre network regulatory framework, in May 2019 the New Zealand Commerce Commission released discussion papers on the methodologies to determine the critical inputs (for example, cost of capital, asset valuation and cost allocation) required to calculate Chorus' regulated asset base and the maximum allowable revenue/prices it can charge. Draft views on these input methodologies are due in November 2019 and a final decision is expected in June 2020. All this is in preparation for the ultra fast broadband, or UFB, roll-out program, which is over 70% complete (on track to achieve targeted 87% coverage by the end of 2022), with take-up of the fibre network already over 50%. Currently, the UFB wholesale pricing is governed by wholesale contracts agreed with the government but the plan is for the new regulatory framework to take over from January 2022, to ensure that Chorus and the local fibre companies do not earn excess returns by overcharging consumers and compromising on the quality of their fibre networks.