If everything went according to Chorus' (ASX: CNU) plan, the company would be set to continue churning out stable free cash flows for years to come. The New Zealand-based telco enjoys a natural monopoly position in its business of wholesaling traditional copper phone and internet connections. Not only that, it also won the contracts to build most of the next generation fibre network through New Zealand's version of the NBN. So why does this company find itself struggling to formulate a viable business model?
On the surface Chorus looks cheap. A company with such huge market share and opportunities for growth would normally trade at a price to earnings multiple of fifteen or more. Instead, Chorus currently trades at a dirt cheap trailing price to earnings ratio of 4.8 times – a valuation that has led many investors to stop and take a second look. But despite all of the company's advantages, there is one big reason that low valuation is justified.
That reason, in a word, is regulation.
In November of last year, New Zealand's Commerce Commission announced that Chorus would be forced to reduce the price that it charges for traditional copper broadband connections by around 50%, effective from December 2014. Chorus has estimated that this will reduce EBITDA by around $130 million. When you consider that Chorus' annual profit in 2013 was only $157 million, you get some idea of how big the impact from this regulation will be.
Between a rock and hard place
We met with Chorus at their head office in Wellington during a recent research trip to New Zealand, and it was readily apparent just how restricted the company is. By regulating down the price of existing broadband connections, the Commerce Commission has not just put a huge dent in Chorus' ongoing profitability – it has also reduced the incentive for customers to switch to Chorus' new ultra-fast fibre network.
A key strategy to encourage users to upgrade from their traditional copper broadband to the ultra-fast fibre network was to make the pricing attractive. Chorus would start off by wholesaling its entry level fibre plans below the cost of traditional broadband in order to encourage users to make the transition. With existing broadband prices now regulated to fall by almost half, that relative pricing advantage will be lost.
Chorus is squeezed on all sides. The company is contractually obligated to the New Zealand Government to continue building out the fibre network, even though it knows uptake will be much slower than planned. At the same time, the profitability of the company's core business will fall dramatically when the new pricing regulations come into effect – cutting away the very cash flows that were intended to fund the build out.
Chorus finds itself having to take desperate measures to maintain profitability. In recent market updates the company has announced that it is considering cutting capital expenditures on its existing copper lines to below maintenance levels. In other words, let its core copper network degrade into a state of disrepair.
David vs. Goliath
Part of the reason that Chorus is facing such onerous regulatory restrictions is that it has been completely outfoxed by its smaller rivals, who have been able to turn the tide of public opinion against the company.
ISPs that purchase broadband from Chorus stand to gain from a regulated fall in wholesale prices. In 2013 they launched a sophisticated public relations effort that was able to brand the current broadband pricing a "copper tax". At the forefront of these lobbying efforts were Callplus and its residential ISP brand Slingshot. That 'Slingshot' moniker is no coincidence. Just as David beat Goliath with his trusty Sling, the brand was founded to challenge the then all-conquering giant Telecom New Zealand (ASX: TEL) that Chorus was later spun off from.
If there is one thing we can all agree to hate, it's tax, and following this "copper tax" campaign, the political support to overturn in the Commerce Commission decision quickly dissipated. There is still one further Commerce Commission review to be completed by December this year, but until then the uncertainty will remain.
Foolish takeaway
If we are looking backwards then Chorus' valuation of 4.8 times trailing earnings seems too good to resist. Combine this valuation with the company's natural monopoly position and it is easy to see why bargain hunters have been interested.
But investing is about looking forwards, not backwards, and the regulatory changes on the horizon make for a bleak future. Management are hoping that the Chorus Goliath can pick itself up off the mat, but until a favourable regulatory review is received, David seems well placed to be victorious – and Chorus is best avoided by investors.
