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Sell Chorus, says Deutsche Bank, as regulatory risk multiplies

Friday 21st June 2013

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Telecommunications network owner Chorus faces too much regulatory risk and too little political will to overcome the cost blow-outs and pricing uncertainties under contracts to roll out the ultra-fast broadband network, say analysts for Deutsche Bank.

In a 33 page report, the local branch of the global investment bank puts a "sell" recommendation on Chorus shares, targeting a share price over the next year of $2.29, compared with $2.57 two days ago, when the report was released.

The shares have slipped 4.2 percent today to $2.26, a low point since its separation from Telecom and listing as a separate entity in November 2011. The stock is down 20 percent this year.

The fundamental problem for Chorus is that it is an "infrastructure stock missing the characteristics investors require."

Regulated infrastructure stocks are often favoured because they have predictable earnings, often thanks to regulated rates of return, well-established and predictable market share, and known costs.

But none of those currently applies to Chorus.

"Chorus is lacking: a well-defined regulatory framework; stability in revenue and earnings outlook, and hence dividends; confidence in capital expenditure and the relationship between capex and returns," say Arie Dekker, a research analyst with Deutsche's retail broking subsidiary Craigs Investment Partners, and Vikas Gour from Deutsche's Sydney office.

The regulatory uncertainties are a combination of the short term and unexpected efforts by the competition watchdog, the Commerce Commission, to slash the price of copper wire services which compete with fibre, and a range of unresolved longer term issues.

Chorus faces potential for stiff competition not only from mobile broadband, but also from retail telecommunications providers such as Telecom, which could choose to unbundle some of their copper-based services and compete in backbone infrastructure with Chorus.

The local fibre companies rolling out the 30 percent of the national UFB network that isn't covered by Chorus's contracts face the same pressures, the report says.

While it argues a case exists for greater government support in clearing up regulatory settings, allowing greater flexibility on the UFB rollout timetable to give Chorus opportunities to manage its costs better, and to push fibre up-take, Deutsche sees little likelihood of any such action occurring.

"We do not sense relief from the Crown on onerous contracts that could ease capex pressures or provide confidence in UFB take-up," the report says. "The government is progressing matters on the regulatory front but copper pricing could fall short and changes to the framework is subject to political risk over several years."

Nor does there appear to be likely movement to alleviate some $500 million of estimated unbudgeted costs associated with the greater than forecast cost of supplying UFB connections between the network and consumers' premises, including households, apartment buildings and commercial and public buildings.

That equates to a value loss of around $50 million a year, which Chorus or customers, or a combination of both, will need to bear, the report says.

Accordingly, Deutsche has cut its dividend forecasts for Chorus for the 2015 financial year to 18 cents per share, down from 25.5 cents previously, with this change underpinning the substantially reduced share price target.

There could be upside if the copper pricing were finalised swiftly, confidence in the costs and take-up rates for UFB were improved, and if there was confidence in a "fair and stable regulatory framework."

The report effectively accuses the government of failing to give its flagship UFB policy sufficient support now it is running into difficulty and of underestimating the scale of the challenge in a large, lightly populated country, and in the absence of international precedents for guidance.

"The government has done a good job in getting the UFB underway much more cost effectively than Australia," the analysts say, but there is no sense "that the government believes that further intervention or funding support is required."

Likewise, the government-owned vehicle overseeing the UFB construction, Crown Fibre Holdings, is seen as having sought to "exert leverage rather than provide support."

"With the Crown negotiating a very strong contract, better outcomes for Chorus depend not just on their own actions but on the level of flexibility and support the government is willing to provide."

For example, Chorus was identifying ways to bring parts of the UFB installation back within budget, but was unable to gain any time extensions on its contractual timelines, meaning its ability to apply savings to the project were reduced.

"The shift from broadband copper to broadband fibre does not seem to be of an urgent enough nature that a longer time frame would matter.

"With a lack of certainty on both the pricing and regulatory framework that will apply beyond 2020, investors are very exposed to the impact of avoidable costs on return expectations."

Deutsche does expect some government action in the next year, and puts greatest odds on legislation before the 2014 election to change the pricing principles the Commerce Commission applies to the vexed current issues of pricing for unbundled bitstream access and the unbundled copper local loop.

The report also laments the apparent lack of a bi-partisan political approach to the underlying regulatory issues, since they are expected to take three to five years to address and are therefore likely to span the life of more than one government.

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