CNU - Chorus

[Snoopy]

Normalised profit is divided by shareholders equity at the end of the financial year

FY2017: $131.7m / $944m = 14.0%

FY2018: $97.2m / $1,022m = 9.5%

FY2019: $65.6m / $979m = 6.7%

FY2020: $62.0m / $927m = 6.7%

FY2021: $52.3m / $948m = 5.5%

At no time over the last five years has 'Return On Equity' exceeded 15%

Conclusion: FAIL TEST

Normalised profit is divided by shareholders equity at the end of the financial year

FY2018: $97.2m / $1,022m = 9.5%

FY2019: $65.6m / $979m = 6.7%

FY2020: $62.0m / $927m = 6.7%

FY2021: $52.3m / $948m = 5.5%

FY2022: $48.3m / $1,029m = 4.7%


At no time over the last five years has 'Return On Equity' exceeded 15%. And I don't like the multi-year trend.

Conclusion: FAIL TEST

SNOOPY

[Snoopy]

'Net Profit Margin' is the 'Normalised Net Profit After Tax' divided by 'company sales' over the financial year

FY2017: $131.7m / $1,040m = 12.7%

FY2018: $97.2m / $990m = 9.8%

FY2019: $65.6m / $970m = 6.8%

FY2020: $62.0m / $959m = 6.5%

FY2021: $52.3m / $947m = 5.5%

A long commentary for FY2020. A somewhat shorter assessment for FY2021: Yikes!

Conclusion: FAIL TEST

'Net Profit Margin' is the 'Normalised Net Profit After Tax' divided by 'company sales' over the financial year


FY2018: $97.2m / $990m = 9.8%

FY2019: $65.6m / $970m = 6.8%

FY2020: $62.0m / $959m = 6.5%

FY2021: $52.3m / $947m = 5.5%

FY2022: $48.3m / $965m = 5.0%

Pretty hard to see any ability to raise margins when the trend is relentlessly down over five years.

Conclusion: FAIL TEST

SNOOPY

[Snoopy]

A cursory assessment of Chorus would suggest this is the place to put your money. The internet is the growth engine of the 21st century. Fibre is the best fast technology and Chorus is a monopoly provider of fibre. What is there not to like?

A closer Buffett style inspection tells a very different story. Underlying 'earnings per share' have roughly halved over the last three years. If you believe the company's own cost of capital assessment, earnings now barely cover its cost of capital. And net profit margins remain under intense pressure. We have to bear in mind that Buffett assessments are not friendly towards capital intensive companies. So it is no surprise that under the spotlight of the Buffett criteria, Chorus sings a woeful song.

Chorus last traded on market at a price of $7.76. Based on FY2020 normalised earnings, this is an historical PE ratio of 46.7. That seems incongruous with a low growth company with margins under pressure. Is this evidence that 'Mr Market' truly has gone mad? The hindsight of history may yet prove this to be true. At these prices, you would have to assume that Warren Buffett would be looking at a different home for his investment cash.

Conclusion: Warren would give Chorus the big 'thumbs down' as an investment prospect

P.S. There is a postscript to the Chorus story. It is a company in transformation that is not reflected in this 'historical' Buffett style analysis. Roll out of the fibre cable nationwide is nearing completion. With future calls on capital drastically reduced, but depreciation on the network assets remaining high, from FY22 we will transition to a dividend policy based on a window emerging where cashflow will greatly exceed profitability. In Chorus's own words from the FY2021 result presentation, Slide 21:

"From FY22 we will transition to a dividend policy based on a pay-out range of free cash flow▪free cash flow will be defined as net cash flows from operating activities minus sustaining capex."

It is the expectation of significantly increased dividends well above sustainable declared profits that has investors salivating. What kind of dividends might shareholders expect from FY2022 onwards? The answer to that question will drive the direction in which my 'Chorus' research will now head.

Ok time to come clean. Evaluating Chorus against he Buffett criteria was a set up for failure. Why? Because the key to a Buffett style halo company is efficient use of assets. Clearly if you have just made a massive capital investment, as Chorus have done in their broadband network, -ahead of demand-, that network will not be used efficiently from day 1. Furthermore other 'network companies', like the power distribution companies, have built up their assets over decades. Many of those assets will be on the balance sheet at 'historical cost'. It doesn't take a genius to figure out that if your costs are largely historical, but your income is in present day dollars, that is a superior business model to Chorus.

Like the gentailers, Chorus is now a 'cashflow story'. If we evaluate Chorus against the more traditional metric of 'underlying earnings' (or 'normalised earnings' as I put it), Chorus, at $7.85, is currently trading on a PE ratio north of 70. No that is not a misprint!

If we look at the headline profit trend, Chorus is now climbing out of the profit dip that occurred when the network building costs were at their peak. However, once I normalise that profit for each year, this is not the case. Normalised Chorus profits hit new lows over FY2022. The fact that imputation credits on dividends have vanished is indicative of a company making next to nil real money in 'profit' terms. I contacted the CFO of Chorus about this and he claimed it was a 'depreciation issue', and that ultimately imputation credits would return. He was very coy as to when that might be though!

For reasons I have just outlined, I am not too worried about return on equity being low. What is of more concern is the ever reducing net profit margin on revenue that is not growing. I can forgive profit going down if it is a depreciation issue. But I am concerned about the flat revenue. One aspect of this is that -perversely-, the more people nationwide that move to fibre broadband (the barrow that Chorus is pushing), the more people who will move away from Chorus copper onto one of the regional fibre networks that Chorus does not own. And when 'regions' not fiberised by Chorus encompass such populous areas as Christchurch and Hamilton, that will hurt Chorus.

From my brief brush with members of the Chorus leadership team, my feeling is that the company is being run on a 'build it and they will come' mentality. There is nothing wrong with that, provided forward sales projections are realistic. The Australian equivalent company, NBN (National Broadband Network) is not so technology tunnel visioned. NBN use a couple of geo-centered satellites and wireless broadband to cover remote communities. So NBN is a 'technology agnostic' company. Personally I think the threat of wireless broadband is being underestimated by Chorus, and that they will have trouble convincing many 'hold outs' from fibre to switch over. On top of this we have the heavy hand of government regulation that caps overall revenue that may be taken by Chorus over a financial year. And the, according to Chorus, unrealistic cost of capital assumptions that have lead to such revenue caps.

The wrap: Chorus is clearly not a Warren Buffett style target investment. Whether it is a good cashflow style investment will require some more digging on my part. Stay tuned.

SNOOPY

[Snoopy]

The other point I really don't understand is the savings in depreciation of $27m (AR2020 p43) that can be obtained because Crown Funding has been used. How can the book state of the Chorus assets be affected by how those assets are funded? Surely depreciation is a function of wear and tear and maybe technical obsolescence?

5) is the "book state" of the assets actually affected by crown funding? (depreciation yes, book value no) But more importantly, where on the Balance Sheet did the credit to depreciation come from? And what is the forecast profile of it's amortisation?

Some more thoughts on this more than 18 months on.

I have established that all of the Crown Infrastructure Partners (CIP) funding that has been used to partially fund the construction of the Chorus broadband network will have to be repaid to the crown in full. For IFRS accounting reporting purposes, interest free funding (which is what the CIP funding is, until repayments become due) is deemed to distort the operational picture of Chorus. Thus, for IFRS reporting purposes, Chorus is forced to introduce the concept of 'notional interest' (which in the operating world is never charged nor paid, as evidenced by the fact that the IRD has ruled it is not tax deductible) to reflect what would happen if these funds were borrowed on more commercial terms.

Whatever is presented via the annual report to Chorus shareholders, the equivalent year annual accounts submitted to the IRD will be different set: a set with all of the 'notional entries' removed (or more correctly never created in the first place). This is IMV, one of the reasons that Chorus is 'apparently' paying a higher tax rate than the statutory 28% corporate rate. One driving part being the 'notional interest' that is so carefully added to the interest bill in the shareholder accounts, - is (from the perspective of the IRD), actually supplementary 'hidden profit' that needs to be taxed. More correctly 'notional interest' should be referred to as a non-deductible expense. IOW it is an expense in the books that cannot be claimed as a deduction for the purposes of calculating the year end income tax expense and would not form part of anything submitted to the IRD. Simplistically, the tax calculation is expressed: NPBT + non-deductible items = taxable profit.

Similarly the 'reduction in depreciation', brought about by crown funding via CIP, I do not believe is real either. (AR2022 p20: "depreciation credit recognised in the profit and loss in relation to CIP securities are non‑taxable"). It is untenable to me to imagine that the boffins at IRD should agree that the rules on depreciation of assets should be altered, simply because some of the funding of the building of those assets is 'interest free' via CIP. From a Chorus shareholder perspective, this means that the 'discounted' portion of depreciation is being time shifted further out into the future. The discounted depreciation will still be claimable in the future. But for now, profits declared today from a Chorus shareholder perspective are increased because of this IFRS mandated adjustment.

My next step will be to create an 'alternative profit picture', similar to that I believe is seen by the IRD, where I add the notional interest back onto income and restore the depreciation claimed back to what would have been claimed had no CIP implied 'depreciation discounts' ever existed.

SNOOPY

[Snoopy]

My next step will be to create an 'alternative profit picture', similar to that I believe is seen by the IRD, where I add the notional interest back onto income and restore the depreciation claimed back to what would have been claimed had no CIP implied 'depreciation discounts' ever existed.

	FY2018	FY2019	FY2020	FY2021	FY2022	Total
Net Profit After Tax (Declared)	$85m	$53m	$52m	$47m	$64m
add CIP Notional Interest Deducted	0.72x $17m	0.72x $22m	0.72x $29m	0.72x $34m	0.72x $39m
subtract Depreciation Discount	0.72x ($22m)	0.72x ($25m)	0.72x ($27m)	0.72x ($29m)	0.72x ($27m)
equals IRD Adjusted NPAT	$81m	$51m	$53m	$51m	$73m
Implied Income Tax Expense (@28%)	($32m)	($20m)	($21m)	($20m)	($28m)
add Reinstatement of tax on Building Depreciation			$5m
subtract Prior Period Tax Adjustment					($6m)
add Other Non-taxable adjustments	($2m)	($3m)	($5m)	($5m)	($6m)
equals IRD Adjusted Tax total (As calculated)	($34m)	($23m)	($21m)	($25m)	($40m)	($143m)
Income Tax Expense (Declared)	($37m)	($25m)	($21m)	($25m)	($42m)	($150m)
Tax Paid Actual (Declared in cashflow)	($30m)	($3m)	($12m)	($1m)	($14m)	($60m)
Current Tax Expense (Tax Note 14)	($16m)	($6m)	($1m)	($1m)	$3m	($21m)

Notes

1/ To calculate the 'Implied Income Tax Expense' at 28% from NPAT: (NPAT)/(1-0.28) - (NPAT) = 'answer'
2/ Numbers referred to in the above table as 'declared' are from the respective Profit & Loss statements.
3/ 'Other non-taxable adjustments are taken from section 14 'Taxation' of the respective annual reports.

--------------

Discussion

Please note that I am using some of the information from Ferg's post 2826 (thanks Ferg) to more correctly explain some of the terms and concepts in more recognised accounting terms.

I am working on the assumption that 'income tax declared' cannot be fudged by IFRS. IOW the amount of tax paid to the IRD is the same, no matter what perspective a company takes on how, and over what timeframe, other costs should be attributed. That means the figures of the second to last two rows of the table above should be the same.

One explanation of a deviation in the numbers reported between each of the two referred to rows could occur because I haven't accounted for tax payments from one year spilling over into adjacent years. Specifically I am thinking about payments made in advance called 'provisional tax' and payments in arrears called 'terminal tax'. The timing of such tax payments differ to the income tax expense declared in the annual report. But I am hoping that because Chorus is a closely defined predictable business, any such errors caused because of tax payment timing will be minor.

'Other non-taxable adjustments' (as tabulated above) that increase the actual tax paid above the statutory rate are unspecified but could include items like:

a) Permanent differences which are non-deductible items (such as some legal fees, 50% of entertainment, some IFRS adjustments etc). Note that I have included one class of permanent difference 'notional interest' in its own separate row, further up the table, AND

b) Timing differences claims which vary 'year to year' and usually unwind to a net impact of zero over a long enough time horizon (e.g. asset depreciation may be accelerated or retarded for IRD purposes vs accounting purposes, and the deductibility of holiday pay liabilities are subject to non-straightforward rules etc.) Note that I have reversed the contrary 'slowed depreciation rate', that is a consequence of CIP crown funding, in a separate line in the table above.

A separate issue is the 'Rural Broadband Initiative' (RBI) assets, funded by non‑taxable government grants. The accounting amortisation of RBI government grants and RBI accounting depreciation recognised in the profit and loss are non‑taxable and tax depreciation is not claimed (Refer AR2022 p20).

Conclusion

My measure of how well I understand the tax, and hence tax credit, position of Chorus is how well the third and fourth to last lines in the above table agree. FY2020 and FY2021 are in agreement, FY2022 and FY2019 are out by $2m and FY2018 is out by $3m. Reporting rounding errors could account for around $1m of those differences. Temporary differences from moving tax expenses could account for the rest. However, if temporary differences were the explanation, I would expect that over the years these differences in overpayments and underpayments would balance out. If you inspect the picture of the last five years by comparing the totals of the second and third to last table rows, it looks like underpayment of income taxes is entrenched.

Furthermore I would expect a Rural Broadband Initiative (RBI) effect, where construction is funded by grants and no depreciation is claimed. From AR2022 p20:

"RBI assets were funded by non‑taxable government grants. The accounting amortisation of RBI government grants and RBI accounting depreciation recognised in the profit and loss are non‑taxable and tax depreciation is not claimed."

If depreciation of RBI is not claimed, does that not mean that profits will increase in that arm of the business? Thus more tax will be paid on any RBI profits, thus increasing the tax bill above the statutory 28% rate?

I admit that I am speculating and I don't fully understand what is happening with the tax bills here. Nevertheless, I consider that I have identified enough 'wriggle room' in the taxation picture that could explain why my calculated 'IRD Adjusted Tax total' and the declared 'Income Tax Expense' are not in perfect agreement. Thus I believe my adjusted net profit figures, where notional interest and depreciation discounts are removed, provide a better representation of where the company is headed profit and tax wise than the IFRS reporting sanctioned and massaged 'official' NPAT figures.

SNOOPY

[Ferg]

Snoopy

I imagine the CNU tax will take quite some time to unpick so I'm not going to try, but I have a couple of pointers.

1/ Ensure your phraseology is correct in that tax "declared" and tax "paid" will be 2 different numbers. Payments made in advance are called provisional tax plus there are payments in arrears called terminal tax. The timing of such tax payments differs to the income tax expense declared in the annual report. Information on payments will be sourced from the cash flow and should not go anywhere near your analysis (I suspect they have not). Instead you want to work with the numbers in the P&L and the notes.

1a/ I would say ignore the Balance Sheet numbers and accompanying notes - this is where timing differences between the declared expense in the P&L and tax payments appear. But on reflection, if this shows the amount declared to the IRD for the year, before the deduction of any payments for that year, you might get the amount declared to the IRD from these notes.

2/ When you say this:

One driving part being the 'notional interest' that is so carefully added to the interest bill in the shareholder accounts, - is (from the perspective of the IRD), actually supplementary 'hidden profit' that needs to be taxed.

Whilst the concept is correct, the phraseology is not quite right. It is not "hidden profit" per se; rather it is a non-deductible expense. IOW it is an expense in the books that cannot be claimed as a deduction for the purposes of calculating the year end income tax expense and would not form part of anything submitted to the IRD. Simplistically, the tax calculation normally looks like this: NPBT + non-deductible items = taxable profit.

3/ Remove the amount (if any) classified as deferred tax that has been included in the income tax expense note that supports the income tax expense value in the P&L. Normally it is split between "deferred tax" (more on that later) and "current tax". You want to work with the "current tax" value only. I believe that will usually be the figure declared to the IRD, unless there are other 1 off adjustments which I see you have noted. Per note 1a above this should match the value that was added to the "income tax liability" account per the notes to the Balance Sheet.

4/ There will be other non-deductible expenses (much like the CIP interest) that will muddy the waters. There are two types, being
a) permanent differences which are non-deductible items (such as some legal fees, 50% of entertainment, notional interest, some IFRS adjustments etc), and
b) timing differences claims which vary year to year and usually unwind to a nett impact of zero over a long enough time horizon (e.g. asset depreciation may be accelerated or retarded for IRD purposes vs accounting purposes, and the deductibility of holiday pay liabilities are subject to funny rules etc.) Such timing differences are usually detailed in the deferred tax notes and these differences give rise to the deferred tax liability (and in some cases a deferred tax asset).

I suspect IFRS 16 might also muddy the waters. And sometimes there is non-assessable "income" (per the RV's) etc. which is unlikely in this case. But the point is that there may be any number of adjustments which are not separately disclosed in the accounts, but you may find a summary of these in the notes to the accounts that support the value for "income tax expense" in the P&L.

5/ I recommend find the tax liability declared to the IRD, which is probably the "current tax" portion of the income tax expense (note this is not the prima facie value per the tax calc note). Once you have that work backwards to see what is the taxable NPBT versus the declared NPBT per the annual report. Then work on pre-tax values for the differences between the two (pre tax is easier) as CNU will have done in their note supporting income tax expense in the P&L. Also double/triple check you have all your signs round the right way.

6/ I presume CNU is 100% NZ income and has no income from a higher tax jurisdiction? If there is overseas income, this could be at a different tax rate.

Lots to unpick so good luck.

[Snoopy]

Snoopy

I imagine the CNU tax will take quite some time to unpick so I'm not going to try, but I have a couple of pointers.

1/ Ensure your phraseology is correct in that tax "declared" and tax "paid" will be 2 different numbers. Payments made in advance are called provisional tax plus there are payments in arrears called terminal tax. The timing of such tax payments differs to the income tax expense declared in the annual report. Information on payments will be sourced from the cash flow and should not go anywhere near your analysis (I suspect they have not). Instead you want to work with the numbers in the P&L and the notes.

Yes the 'declared profit' I tabled was straight from the respective 'Consolidated Income Statement(s)'.

1a/ I would say ignore the Balance Sheet numbers and accompanying notes - this is where timing differences between the declared expense in the P&L and tax payments appear. But on reflection, if this shows the amount declared to the IRD for the year, before the deduction of any payments for that year, you might get the amount declared to the IRD from these notes.

The tax note (AR Note 14) contains 'Current Tax Expense' split between the 'current year' (which I am guessing is provisional tax) and 'adjustments in respect of prior periods' (which I am am guessing is terminal tax). I have summed these two figures for each of the five years and added the totals to the bottom of my table, as a curiosity. However, these figures are not representative of the 'Declared tax' from the income statement.

2/ When you say this:
"One driving part being the 'notional interest' that is so carefully added to the interest bill in the shareholder accounts, - is (from the perspective of the IRD), actually supplementary 'hidden profit' that needs to be taxed."

Whilst the concept is correct, the phraseology is not quite right. It is not "hidden profit" per se; rather it is a non-deductible expense. IOW it is an expense in the books that cannot be claimed as a deduction for the purposes of calculating the year end income tax expense and would not form part of anything submitted to the IRD. Simplistically, the tax calculation normally looks like this: NPBT + non-deductible items = taxable profit.

I have added your corrected description (thanks) to my original note, to make sure there is no misunderstanding as to what I am talking about.

SNOOPY

[Snoopy]

3/ Remove the amount (if any) classified as deferred tax that has been included in the income tax expense note that supports the income tax expense value in the P&L. Normally it is split between "deferred tax" (more on that later) and "current tax". You want to work with the "current tax" value only. I believe that will usually be the figure declared to the IRD, unless there are other 1 off adjustments which I see you have noted. Per note 1a above this should match the value that was added to the "income tax liability" account per the notes to the Balance Sheet.

5/ I recommend find the tax liability declared to the IRD, which is probably the "current tax" portion of the income tax expense (note this is not the prima facie value per the tax calc note). Once you have that work backwards to see what is the taxable NPBT versus the declared NPBT per the annual report. Then work on pre-tax values for the differences between the two (pre tax is easier) as CNU will have done in their note supporting income tax expense in the P&L. Also double/triple check you have all your signs round the right way.

	FY2018	FY2019	FY2020	FY2021	FY2022	Total
Deferred Tax Expense (Adjustments wrt Prior Periods)	$4m	$2m			($14m)	($8m)
add Deferred Tax Expense (Depreciations, provisions, accruals, leases & other)	($25m)	($21m)	($20m)	($24m)	($31m)	($121m)
add Current Tax Expense (Tax Note 14)	($16m)	($6m)	($1m)	($1m)	$3m	($21m)
equals Income Tax Expense (Declared)	($37m)	($25m)	($21m)	($25m)	($42m)	($150m)

Notes

1/ Deferred tax figures taken from Note 14 'Taxation'

6/ I presume CNU is 100% NZ income and has no income from a higher tax jurisdiction? If there is overseas income, this could be at a different tax rate.

Yes, no overseas income. All income billed by Chorus comes from New Zealand sources.

SNOOPY

[Ferg]

	FY2018	FY2019	FY2020	FY2021	FY2022	Total
Deferred Tax Expense (Adjustments wrt Prior Periods)	$4m	$2m			($14m)	($8m)
add Deferred Tax Expense (Depreciations, provisions, accruals, leases & other)	($25m)	($21m)	($20m)	($24m)	($31m)	($121m)
add Current Tax Expense (Tax Note 14)	($16m)	($6m)	($1m)	($1m)	$3m	($21m)
equals Income Tax Expense (Declared)	($37m)	($25m)	($21m)	($25m)	($42m)	($150m)

The bold line per your analysis titled "Current Tax Expense" is what has been declared to the IRD. That is exactly the line you want to work with if you are trying to work out taxable profit etc. I recommend take the $3m refund for the last fiscal year, divide by 0.28 to get a pre tax loss of $11m. I think you are trying to reconcile that number to the pre tax profit figure per the annual report. Given that is a loss and prior years are so low, that will explain why there are no imputation credits - IOW there is no taxable profit hence no tax payments -> no imputation credits.

Per this earlier post:

The tax note (AR Note 14) contains 'Current Tax Expense' split between the 'current year' (which I am guessing is provisional tax) and 'adjustments in respect of prior periods' (which I am am guessing is terminal tax). I have summed these two figures for each of the five years and added the totals to the bottom of my table, as a curiosity. However, these figures are not representative of the 'Declared tax' from the income statement.

WRT a specific financial year, provisional tax payments are payments made in advance on the current tax amount. And terminal tax payments are payments made in arrears also on the current tax amount. Deferred tax is never paid - that is why it is 'deferred'.

[Snoopy]

The bold line per your analysis titled "Current Tax Expense" is what has been declared to the IRD. That is exactly the line you want to work with if you are trying to work out taxable profit etc. I recommend take the $3m refund for the last fiscal year, divide by 0.28 to get a pre tax loss of $11m. I think you are trying to reconcile that number to the pre tax profit figure per the annual report. Given that is a loss and prior years are so low, that will explain why there are no imputation credits - IOW there is no taxable profit hence no tax payments -> no imputation credits.

This very sobering moment in the analysis of Chorus's FY2022 result deserves its own one liner, particularly in the context of the AGM addresses which were along the lines of: "Dammit we are doing well!"

"Pre-tax profit declared to shareholders: $106m. Pre tax loss declared to Inland Revenue: ($11m)"

What the ..??##$$!!!!!!.....

SNOOPY