We’d like to sing the praises of Chorus Limited
One investment that has served us well over the past year is a holding in Chorus Limited (ASX: CNU) – the owner of New Zealand’s copper telecommunications network, and a major player in the construction of New Zealand’s Ultrafast Broadband Project – New Zealand’s equivalent of the NBN.
Chorus has always been a slightly unusual holding for us, in that it operates in a highly regulated industry and has experienced some significant regulatory headwinds in recent years. In addition, its near term growth prospects are not as bright as we would normally like to see[1], and we contemplate a few years of declining customer numbers.
It was the regulatory headwinds that initially caught our interest in CNU. In early 2015 when we first looked at the company, the New Zealand Commerce Commission had set wholesale prices for access to the CNU copper network at a level that caused real problems for the company. Facing a sharp decline in earnings, CNU responded by suspending dividends, halting discretionary capex and managing for cash. Our rationale at that time was that it was in everyone’s interest for access prices to be set at a level that provided network owners with the right incentives to invest, and that over time New Zealand would move towards a regulatory framework that provided the necessary level of certainty and economic return.
To some extent, that expectation has since been borne out. In December, the regulator increased the price to access CNU’s copper network, and the future of industry regulation appears to be heading in a constructive direction, with the government expressing a preference for a regulatory model that will provide a good level of predictability and stability. The details will be worked through in the coming years as part of a Framework Review that will take over from the current regulatory framework from 2020.
One of the key benefits of a predictable regulatory environment is that investors will be willing to ascribe a lower discount rate to CNU’s cash flows, which is good for everyone. A lower cost of capital means that CNU can earn a satisfactory return on investment while charging lower prices for customers. If common sense prevails then this is what should emerge.
For the time being, however, CNU needs to be valued in a way that recognises the remaining uncertainty, and that is what the market appears to be doing. CNU has a number of moving parts and is not straightforward to value, but our assessment is that the intrinsic value lies somewhere north of the current share price using sensible assumptions, even following a good share price run in the past year.
Accordingly, we continue to be happy owners of the business. We can see some upside in the event that regulation continues to move in a positive direction, but we are comfortable with valuation even if it doesn’t. In the current market it’s not easy to find valuation cases with more upside than downside.
[1] CNU doesn’t own 100% of the UFB, and so will lose customers from its copper network to UFB competitors in coming years
Montgomery owns shares in Chorus Limited.
Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.
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