Why Chorus Limited looks undervalued

One slightly unusual holding in our domestic funds is Chorus Limited (CNU), New Zealand’s largest owner of telecommunications networks. CNU has had a bumpy ride this last year, but we think the market has marked it down too far due to regulatory uncertainty.  If we are right, then the company should re-rate.

CNU’s assets include the copper network that covers the entire country, and a majority of the fibre optic network that is being installed to replace it.  It is an unusual business for us because, while most of our holdings show a healthy growth outlook, we actually expect CNU’s revenue to go backwards in the years to come. This is because CNU doesn’t own all of the new fibre infrastructure in New Zealand, and will go from being a monopoly provider of fixed line across the entire country, to being a monopoly provider in most of the country.  Existing customers will be lost to other fibre owners in certain areas as the migration to fibre runs its course.

Beyond that, some analysts see a healthy revenue outlook for CNU, based on rising demand for broadband data.  However, while we agree that demand for data is rising, we don’t see that as providing a particular tailwind to CNU’s revenues.  We anticipate that regulation of the NZ telecommunications industry (which is still a work in progress) will develop in such a way that network owners will be able to earn a regulated return on capital, and so returns will be a function of capital invested and the discount rate chosen by the regulator.  As faster data speeds can be delivered for limited incremental capital, demand for increased data doesn’t impact much on our assessment.

We think that a lot hinges on the where the regulator settles.  In theory, the regulator assesses the capital employed in CNU’s network, determines a cost of capital and calculates the revenues that are needed to ensure the cost of capital is covered. The price for access to CNU’s network assets (and therefore revenue) falls out of this.

The challenge is that there is a lot of room to debate the capital employed and the appropriate discount rate, and so a lot of different pricing outcomes are theoretically possible.  This uncertainty currently weighs on CNU, and will continue to weigh until the details of the regulatory framework are fully resolved.  However, having observed the regulatory and market developments in New Zealand in recent years, we believe that the range of practical pricing outcomes is relatively narrow.

In the course of building its fibre network, and making changes to the regulated pricing for the existing copper network in recent years, New Zealand has effectively experimented with different levels of broadband pricing.  In 2012, copper prices were arguably too high, but in 2013 they were reviewed down to a level that stifled investment, which is in no-one’s long term interest.  More recently, copper access prices were increased to a level that appears to work for everyone.

In the case of fibre, prices need to be set at a level that is high enough to encourage investment (which is happening) but low enough relative to copper prices to facilitate migration (which is also happening).  In other words, it appears that New Zealand has now found the right balance of pricing to achieve the relevant policy objectives – cheap broadband, while still encouraging network owners to invest.  Accordingly, we anticipate that a big change in prices from here is unlikely. The consequences of moving too far in either direction would be significant, and there is plenty of scope for the regulator to arrive at capital and discount rate assumptions that preserve the status quo.

This conclusion allows us to forecast CNU’s earnings and cashflows, and then find out what discount rate the market is effectively pricing into CNU shares.  When we do that, we see a significant discount priced in for regulatory uncertainty.  If we are right about the outcome of the regulatory review process, this uncertainty is overstated, and the value ascribed by the market to CNU should rise as the regulatory framework review is completed and the uncertainty resolved.