Paul McBeth: Where to next for Chorus?

Contractors working on ultra fast broadband in Tauranga.

COMMENT:

Chorus execs should feel pretty chuffed after getting some serious wins in last week's draft decision on how its regulated prices will be set.

Their previous experience with the Commerce Commission tied them up in knots when veteran telco managers thought they'd be simply tweaking the existing copper pricing principles.

That history was probably weighing on investors' minds. But when the regulator came out with its draft input methodologies for setting regulated fibre prices the response was swift - a 6.9 per cent bump on the day.

Salt Funds Management managing director Matt Goodson noted that the outcome was better than feared. Provided it remains intact, it will make a big difference to Chorus in real money terms.

Long-time Chorus backer L1 Capital has been making that call for quite a few months. It owns about 15 per cent of the company, buying in five years ago at $1.60. Even in the mid-$5.60s, the fund manager described the stock as extremely under-valued.

Ultrafast broadband connections in Napier.

The reasoning was that with a more favourable regulatory regime, Chorus can carry a higher level of debt and spit out bigger returns in the form of cash dividends.

That was pretty much affirmed when Standard & Poor's came out after the commission's decision and said it wouldn't downgrade the network operator's credit rating if it carried a bit more debt on its books.

Jarden's Arie Dekker and Grant Lowe were more ambivalent and have a number of questions about where the regulated framework will end up. In the short-term, Chorus can step up its dividend payments as the $1 billion infrastructure spend wraps up.

Where it goes next is a bit trickier, particularly due to the rise of fixed-wireless broadband.

Spark had 695,000 broadband customers at the end of June, of which 140,000 were on the mobile substitute, bypassing the need to pay Chorus. The other 306,000 on fibre and 249,000 on copper all come with the Chorus cost eating into Spark's margins.

Vodafone's decision to follow suit doesn't bode well for the fixed-line network operator, which counts the pair as its two biggest customers.

Revenue for access to the wholesale network has already shrunk. Spark accounted for $433 million of Chorus's $970m annual revenue in the June 2019 year, down from $489m a year earlier. Vodafone's $197m contribution was largely flat from the $203 million in 2018.

Overlay 5G technology – which makes the economics of wireless broadband that much more attractive – then it's little wonder the threat was taken seriously in the Commerce Commission's draft ruling, even if stranding of Chorus assets was more a slim chance than a probability.

How quickly the 5G roll-out will come is still unclear. Photo / 123rf

For S&P, it's a big enough risk to not treat Chorus as a utility.

"Vertically-integrated mobile network operators are incentivised to bypass fixed-line wholesalers in order to capture the full value chain. Average data usage statistics are skewed toward high-volume users, leaving a sizeable addressable market available to mobile network operators, who are likely to target a sizeable market segment of lower demand users in higher-density metropolitan locations," it said.

That's a far cry from the 2011 Telecom demerger document, when Grant Samuel was telling shareholders that the superiority of fixed-line services meant the risk from switching to mobile internet wasn't substantial.

S&P reckons fixed wireless could account for about 15 per cent of the broadband market in the next few years and even more longer term. And that's not mentioning the other mini-monopoly fibre companies switching Chorus customers from copper to fibre.

For Spark and Vodafone, fixed wireless services are the cream on what are already significant cash cows. Spark's annual free cash flow is tracking around $350m, whereas Vodafone's cash flow was enough to tempt canny investor Infratil to buy the telco.

How quickly that 5G roll-out will come is still unclear.

Fixed wireless could account for about 15 per cent of the broadband market in the next few years and even more longer term, according to S&P.

Spark and Vodafone have to get their hands on the spectrum first, which is slated for next year but may become a problem if the Government can't win over iwi.

And to complicate matters further, trade tensions between the US and China, and South Korea and Japan, may disrupt technology supply chains, making it even harder to build a new network.

Should that happen, the fixed line networks currently delivering screeds of information at ultrafast speeds up and down the country will still be doing the job.

Since Chorus and the smaller players started building the network, almost 484,000 households and businesses have signed up out of the 831,000 who are able to access it.

Not a bad effort considering Telecom had just 4000 fibre customers when Chorus was getting carved out.

So when Chorus starts generating free cash flow when the network is completed the new rules are in place, Jarden analysts predict a near-50 per cent hike in the dividend in 2022, reflecting a gross yield of 8.8 per cent.

Even when interest rates weren't near zero, that would be a hard return to ignore.