The final EY report on Chorus says the company could institute cashflow savings measures to reduce its $1 billion UFB funding shortfall to $200 million to $250 million.
If the funding gap is not closed, Chorus [NZX:CNU] will struggle to complete the UFB fibre rollout, EY says, backing the government's line against Commerce Commission-mandated price cuts that National does not have majority support to overturn (the Coalition for Fair Internet Pricing was quick to claim the report backed its line that Chorus doesn't need a bailout; read its take here).
Contrary to the Prime Minister John Key's assertion that Chorus "could go broke" if the ComCom's copper price cuts go through (as they now seem destined to), EY says there are a number of straightforward ways to close the funding gap; Chorus' dividend is double that of comparable companies, by its analysis; there's room to increase Chorus' debt without breaking its banking covenants, and there's scope to cut costs.
Specifically on dividends, it says $290 million could be cut from payouts to shareholders over the 10-year rollout (the UFB is due to be completed in 2020). It suggests a two-year "dividend holiday" then 12.75 cents a share untill 2020.
Last year, Chorus paid out 24c a share or $95 million of its $171 million net profit as dividends to shareholders.
While analysts had seen dividend pain for shareholders, EY's prescription, if followed, is more severe than most had picked. Forsyth Barr, for example, had been expecting a two-year suspension, but not halved payouts beyond that.
EY says Chorus' Chorus had a dividend yield of 10.3% in the year to June 2013, unsustainably higher than the 4.3% NZ and 6.7% Australian peer averages.
The EY report adds, "We have not considered the potential effect the dividend holiday may have on any initiatives to raise further capital (such as a capital raising) or on the Chorus share price."
Why not? That was outside of the report's terms of reference, EY says.
The report also notes Chorus’ return on equity was 29.7% last year, higher than other infrastructure businesses which have average returns of 12.5% (New Zealand peers) and 11.2% (Australian peers). Vector, which is retricted to an 8.8% return as a regulated lines company, has been hammering this point for some time - but when NBR approached Ms Adams for comment on this point in October, she defended Chorus' 29.7% return.
The EY report notes that even if Chorus meets its savings targets, there are "potential risks and implications":
The cost and capital savings may result in some redundancies [According to its 2013 annual report, Chorus now employs 763 permanent and fixed term employees directly - 248 earning more than $100,000. A further 4434 are employed by by service partners Downer, Transfied, Visionstream and others].
There could be negative brand damage for Chorus as consumers receive a service level that could be lower than that provided today.
Network fault rates could increase as Chorus implement a reactive rather than proactive maintenance strategy resulting in reduced network performance and increased consumer complaints.
It also raises the prospect of the so-called "nuclear option" of Chorus providing a lower service level to retail ISPs (which could see Chorus play by the letter of the law and only supply ISPs with the minimum required copper broadband speed - which is close to dialup - unless they upgrade to more expensive options).
In a brief statement after the final EY report was released, Chorus CEO Mark Ratcliffe said, EY "correctly identify that those [cost cutting] initiatives come with substantial trade-offs."
How to fill the shortfall?
IMs Adams reiterates in a media statement accompanying the final report that
The Government’s UFB initiative has a budget of $1.35 billion and CFH is required to act within this fiscal envelope.
The Government expects Chorus to meet a significant part of the shortfall.
So where does the rest of the shortfall come from?
However, the government has yet to explain how rest of the $200 million to $250 million shortfall will be met if not by Chorus or the taxpayer - and more so given the EY report already includes cost cutting, raising Chorus' debt ceiling by $130 million and the $290 million shaved off dividends. Issuing new shares would be a tough sell.
"The minister has previously indicated that contractual changes could possibly be made to the timing of payments, the structure of payments and some of the specifics of the UFB build that don't affect service parameters or timeframes," a spokesman for Ms Adams tells NBR.
Chorus already has super-relaxed terms for paying back the government's $929 million investment (half of which is in the form of non-voting shares, half in interest-free debt). It does not have to return Crown funds until 2025, and has until 2036 to pay back the funds in full.
And in terms of project timing, at 10 years Chorus' timeframe is already three years longer than Ultrafast Fibre's. The whole idea of the UFB was to to use government funds to speed deployment of fibre, for the greater good of business, given left to its own commercial devices Telecom would never upgrade its network within a decade.
And the company has already cut costs by turning thousands of its unionised linesman into non-unionised independent sole operators, who now work for UFB subcontractors Downer, Transfield and Visionstream, who carry out the day-to-day UFB work. And earlier this year, after Chorus revealed it had underestimated UFB costs by $300 million, it renegotiated its subcontractor deals. Indications are that things are now pretty close to the bone (or sliced into the bone, in the case of Transfield, which embarrassed Chorus during August and September as it was unable to pay UFB subcontractors).
Chorus is currently in talks with Crown Fibre Holdings over various cost-cutting initiatives, which have not been made public.
A rep for Ms Adams office told NBR this afternoon, "The government would like to see talks with CFH concluded early in new year and we'll be monitoring progress closely."
Adams rules out two options
The EY report does not canvas one area frequently raised by Chorus - the cost of consents around the UFB. The company says it could save a lot of time and money and if the UFB was made a "designated service" under the Resource Management Act so it does not have to spend up to two months, or more, gaining the permission of every owner around a right-of-way, or multi-tenanted dwelling, before it can lay fibre.
But Ms Adams appeared to rule-out that option during an Ask Me Anything session with NBR readers, saying RMA changes were "unlikely to provide the best fix."
The minister has also ruled out an move similar to Tony Abbott's incoming government in Australia, which is scaling back its equivalent fibre rollout to reduce fibre-to-the-home to fibre-to-the-premise (or neighbourhood level, with copper retained for the last leg).
Two Chorus fallbacks
Beyond it's jousting with CFH over costs, Chorus two fallbacks.
The company has filed a High Court appeal against the Commerce Commission's copper price cut ruling, which is due to kick in in December 2014. Other regulatory cases in the sector have stretched through years of appeals.
Chorus has also exercised its right to a final pricing principles review by the Commission - a process the regulator says could take two years.
One bill, two views
The current Chorus controversy began with a determination by the Commerce Commission, confirmed on October 31, that the company should cut its wholesale copper line pricing by 23%.
Chorus complained the move would blow a $1 billion hole in its revenue - a figure EY agrees with - dismantling its ability to fund its 70% of the UFB fibre rollout from its copper revenue. The Coalition for Fair Internet Pricing has argued the government's plan for more modest price cuts would merely have seen the balance go into Chorus' shareholders' pockets as dividends rather than subsidising the UFB.
The Coalition argues Telecom (then including Chorus) bid for the UFB in the full knowledge that the Telecommunications Amendment Act (2011) would mean a move to cost-plus copper pricing after three years, and the attendant likelihood of cuts after international benchmarking. The government and Chorus argue that is too narrow an interpretation of the legislation. They say the emphasis should be on copper pricing being pegged to the cost of a replacement network (that is, UFB fibre).
The goverment's origiinal plan to legislate to overturn the Commerce Commission, as outlined in a discussion document released by Ms Adams, was blocked after coalition allies ACT, The Maori Party and United Future made it clear they would not support such a move.
Chorus shares rallied 7.30% on Friday on news Milford Asset Management and ACC were buying into the company, signalling they considered it had bottomed out - dividend risks not withstanding.
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