Description

LONG Telecom New Zealand (TEL NZ & NZT US)

Price (NZ): $2.55

Market cap (NZ): $4.9 b

Enterprise value (NZ): $7.9 b

Average Daily Volume Trades (USD): $19 mm

Thesis

TEL NZ is a long because it is at a positive inflection point in regulatory regimes yet still trades at a discount to intrinsic value at 4.3x EBITDA, 7.8x FCF, and a 7% dividend yield. A spin-off of the regulated business before year end will be the catalyst to re-rate the stock.  

For the last 5 years TEL has been the victim of a punitive regulatory environment. This changed in May of this year when TEL agreed to a long term deal with the government to fund a nationwide ultra fast broadband build-out plan (the “UFB plan”) in exchange for guaranteed pricing on their regulated assets until 2020. The government is now incented to see TEL succeed as TEL is responsible for providing high speed broadband service to the nation, and the government received out of the money warrants on TEL stock so if TEL has outsized performance the government will participate.

In conjunction with the UFB deal TEL is separating into 2 publicly traded stocks effective November 30^th 2011: a regulated land-line utility (New Chorus) and a non-regulated telecom company (New Telecom). We believe this separation will help the street revalue the 2 new companies and bridge to our price target of 3.33/share which is ~30% upside.

Business Description.

New Chorus ($660 mm of EBITDA): the monopoly copper network of New Zealand that provides voice and data service to residential and business customers. Under the new regulatory regime the pricing is fixed until 2020 in exchange for funding a nationwide fiber build-out that we value at a negative NPV of $507 mm. New Chorus will be a low-growth yield-oriented stock that we expect to trade at a 5.5x EBITDA, 8.3x FCF, and a ~7% dividend yield.

New Telecom ($1,145 mm of EBITDA): a collection telecom companies 1) the #2 wireless company in NZ with 40% market share (20% of NT EBITDA), 2) an enterprise network services business  called Gen-i (20% of EBITDA), 3) a retail telecom service provider with 65% market share (20% of EBITDA), 4) an international voice access provider using their own backhaul assets (15% of EBITDA), 5) a wholesaler of fiber in Australia called AAPT (10% of EBITDA), and 6) other miscellaneous assets and intercompany revenues (15% of EBITDA). New Telecom is perceived to be a low-growth telecom company with some challenging headwinds, but we believe that there are significant opex and capex cost cutting opportunities that will allow the company to grow EBITDA LSD and FCF MSD for the next few years.

Regulatory Environment

TEL has been the whipping boy of the New Zealand government for the last 5 years. There were 2 major initiatives forced upon TEL before the UFB deal: anti-trust concerns resulting in de-regulation of the monopoly copper network and a broadband roll-out of fiber-to-the-home.

Anti-trust: in an effort to promote competition and lower telecom prices for the end-consumer the government forced a de-regulation of the copper network. Before the forced operational separation of the copper network asset and the consumer-facing retail business, competitors that bought access on the copper network to resale retail voice and data services complained they were at a disadvantage vs. the TEL retail business due to vertical integration and lack of arms-length pricing. The government agreed and for the past 3 years TEL has spent over $450 mm through the opex and capex line to completely separate the copper network business from the retail service provider (RSP) business. Now the prices offered to the retail facing business of TEL are the same prices offered to the competing resellers.

High speed broadband - A high speed broadband build out for New Zealand has been a political objective for a number of years, much like we have seen in other countries. The latest iteration was a fiber to the node build out that the government forced TEL to embark upon.

The HSB build out combined with operational separation sent capex over $1.0 b annually in 2008-2010 vs. our estimate of capex excluding these exceptional items of $600-$700 mm and our estimate of maintenance capex of $500 mm.

In May 2011, after several years of negotiations, the government and TEL agreed to a all-encompassing nationwide build out of ultra fast broadband (UFB) to 90% of the country (of which TEL is responsible for 70%) which will deliver 50 mbps broadband speeds as the entry level package (the next tier up is 100 mbps). This compares to my current plan on FiOS of 30 mbps. TEL (via New Chorus) will spend ~$1.75 b over the next 8 years to build out fiber to the home (assumes 831k homes passed with a 30% uptake) of which the government is partially funding through $930 mm of zero-cost preferred equity and notes. Our estimate of the UFB project is a negative $500 mm NPV and is included in our valuation. In return New Chorus has guaranteed pricing for their existing and new services to be offered on the UFB network. The government is also getting warrants on TEL’s stock which go in the money if TEL’s stock’s compounds at over 16% annually through UFB project time period.

With the operational separation complete and the UFB agreement TEL’s relationship with the government has gone from being punitive to one where the government is aligned with TEL resulting in regulatory certainty the company has not seen in over a decade.

Financials & Valuation

For the consolidated TEL, PF EBITDA for FY 11 (ending June 30^th) was $1.8 b split between New Chorus ($676 mm) and New Telecom ($1,125 mm). Management is guiding for both companies to be LSD EBITDA growers. As part of the de-merger process an independent analysis was performed by a 3^rd party consultant which models consolidated TEL EBITDA to be flat in FY 12. You can read their 100 page report in the de-merger scheme booklet. Interestingly, that consultant also did a valuation of TEL with a mid-point fair value of 2.75/share vs. the current 2.55 stock price. We assume flattish EBITDA in FY 12 for our valuation.

For New Chorus we use 5.5x EBITDA which is a discount to landline telecom comps even though New Chorus is a more stable business given fixed pricing, low fixed-mobile substitution, and no cable competition. Windstream and Frontier, landline businesses in the US with large secular headwinds, trade at 6.6x and 5.9x EBITDA respectively. 5.5x EBITDA implies 8.7x EBITDA-Capex, 10x EPS, 8.3x FCF, and a ~7% dividend yield. Note that we are capitalizing the UFB NPV into the EV/market cap for these multiples and not including the UFB spend into capex. With the pro-forma capital structure our target price for New Chorus is 75 cents per TEL share.

For New Telecom we use 5.0x EBITDA which is the blended average of the valuations we apply to each of the segments. We use 6x for wireless and gen-i and AAPT, and 3.5x for retail resale and international wholesale which are multiples in line or at a discount to their respective comps. 5.0x EBITDA implies 9x EBITDA-Capex, 15x EPS, 11x FCF, and a 6% dividend yield. This results in a target price for New Telecom of 2.58 per TEL share.

On a consolidated basis these assumptions roll up into valuing TEL at 5.2x EBITDA and 10x FCF and a 3.33/share target price vs. the current TEL price of 2.55 which is 4.3x EBITDA and 7.8x FCF. This seems conservative given our assumption of flat EBITDA and the opportunities to reduce capex spend at both companies and the opex opportunity at New Telecom from headcount reductions.

Management

From meeting both sets of management teams it is clear that they get it. Both companies will adopt a capital allocation policy of paying out close to 100% of FCF to shareholders through dividends and share repurchases. Both companies have NO plans to make acquisitions. Rather, New Telecom has potential divestments in AAPT, Southern Cross, and Hutchinson stock to be executed on post the separation. Both sets of management teams will be incented with RSU’s shortly after the new boards have met for the first time in December.

New Chorus will be run by Mark Ratcliff who was the person in charge of negotiating the UFB deal with the government. He understands what New Chorus is supposed to be which is a low-growth yield-oriented vehicle. His focus will be executing on the UFB project within the scope of their estimates and cutting non-UFB capex to generate FCF growth.

Paul Reynolds who is the current CEO of TEL will be the CEO of New Telecom until they have found a successor. Paul was recruited to TEL from BT to help effect the operational separation. Incidentally BT is the only other telecom company in the world to go through a separation like TEL. Now that the separation is complete he is moving on. Nick Olson, the current CFO of TEL will be the permanent CFO of New Telecom. Their focus will be on headcount reductions and capex savings from simplifying the business after years of neglect during the regulatory separation process.

Catalysts/Timeline

Management is conducting a global road show through October. The demerger is effective November 30^th. We expect to see the analyst community re-initiate on both of the spinco’s in December which should illuminate the sum of the parts discount that we perceive to be in the stock and that the majority of the equity value (New Telecom) is not subject to government regulation vs. current perception that TEL is a heavily regulated stock.

Risks

Risks to New Chorus are 1) the cost projections for the UFB project are too low, capex is higher and FCF is lower than we anticipate, and the negative NPV for the project is more than $500 mm. The risk in the build out is on the connection capex when a household wants to subscribe to UFB. Fortunately we won’t know if this is happening until 2014 or later as expectations for UFB take-up are very low in the first few years. 2) fixed-mobile substitution (cutting the telephone cord) is higher than 100-200 bps a year that would accelerate revenue declines and make it harder to maintain FCF levels. Current substitution is low due to poor wireless network quality, expensive all you can eat voice plans ($100 a month), and free local calling as part of your landline plan. We don’t anticipate any of these issues changing.

Risks to New Telecom are 1) market share losses in the retail resale business could be worse than expected. 2) management is unable to execute on the headcount and capex reductions as easily as they think so cost savings may not counteract the LSD revenue declines we anticipate enough to maintain or grow FCF. 3) New Telecom will still be a conglomeration of several telecom businesses and could trade at a discount to the 5.0x and 11x FCF we value the business at. Potential non-core investments should help mitigate this risk however.

Catalyst