The infrastructure REIT has performed really well in the last nine months since we last discussed it.
The company is quickly diversifying away from WINs issues but at the same time, WIN is fixing itself.
The long-term fundamentals of the business had been ignored for some time but given the roll out of 5G, we think the business is very strong.
The balance sheet remains healthy and cash flow is covering the dividend. As new acquisitions and projects come on line in 2H18, AFFO growth should expand.
We approach the valuation of UNIT from the aspect of a credit investor looking at sustainability of cash flows rather than EPS growth over time to drive the price.
We last wrote completely on UNITI Networks (UNIT) back in September in "Is This 15% Yielder The Deal Of The Year?" In that report, we had a section that was for our members only. In it we advised members to add to their positions, either by acquiring shares outright or by purchasing out-of-the-money call options. This was a way to add more upside given our take that the shares were severely undervalued without adding to your downside risk level.
Since September, shares are up 55% on a total return basis.
We wrote exclusively to members:
We think the risk return is skewed to the upside here but as with any individual "high yield" position, the risk is certainly high. Our base case calls for a $23.50-$24 share price with the dividend staying intact. Upside would be $30.
Shares today are right in that $22-$24 range where we predicted they would be. So the question is, what do we do now? Right now, we think the risk is now fairly balanced and may even be a bit skewed to the downside.
There are several options members can take here. For example, you could simply sell a portion of your position and "play with the house money" still receiving that nice 10.50% yield. Another option is to now sell an in-the-money call in order to capture additional yield and upside while making it more probable you sell at a certain price.
Our allocation is now well over our 2% targeted maximum at 4.6% so we are looking to chop that back to ~2% or lower.
Our thesis was that this unique infrastructure REIT offered up a 15% yield with more upside than downside. We first introduced readers to the stock back in early 2016 when the shares were trading below $18. They quickly ran to over $30 before falling back on the Windstream problems.
We are overall net negative on telecom but mostly on the content delivery side (AT&T, Comcast, etc) and will be detailing our short/cautious case for those stocks soon. However, owning cell tower infrastructure as we move towards 5G rollout makes a huge amount of sense. In a presentation recently, CFO Mark Wallace noted that they plan to build approximately 300 new towers in 2018 focusing more on the U.S.
The company is a high risk REIT that we liken to a junk bond trading below par (giving us capital gains upside). The stock has suffered from the concerns over their ties to their former parent company Windstream (WIN) along with subsequent lawsuits with a hedge fund named Aurelius Capital.
It was a perfect storm of events that coincided with the interim nadir in interest rates in early December. The rise in rates, especially after year end, caused a significant price decline.
We wrote extensively on the lawsuit and the potential scenarios regarding WIN's potential outcomes. One of the potentialities was that WIN would reduce the rental payments to UNIT, which make up approximately three-quarters of UNIT's revenue.
We laid out the framework if a bankruptcy were to occur. In our prior note, we wrote:
The structure of the lease essentially puts UNIT at the top of the capital structure food chain, even above or pari passu WIN's debt. At the end of the day, UNIT has the upper hand in the relationship, something WIN perhaps wish it didn't do in hindsight when it spun UNIT off.
Under a Chapter 11 bankruptcy, WIN has 120 days (plus a possible extension of 90 days) to determine whether it will accept or reject its lease with UNIT. If WIN continues to occupy the property during the 120-210 day period, UNIT is entitled to rent until WIN rejects the lease and surrenders the property, or assumes the lease. The rent would be considered an administrative expense that is a priority claim ahead of all creditors. While it is likely WIN would continue to pay administrative rent while it decides whether to accept or reject the lease; if it does not, then UNIT can file a motion demanding administrative rent. If WIN accepts the lease, then it must continue paying administrative rent as long as it is reorganizing under Chapter 11 protection. WIN must also pay the 0.5% annual escalators embedded in the lease as administrative rent.
If WIN rejects the lease, UNIT is entitled to lease rejection damages equal to one year of rent; however, these damages would only rank as unsecured debt. Given the substantial negative equity on WIN's balance sheet, unsecured creditors will likely recover little if any of what is owed them.
In the very unlikely event that WIN files for Chapter 7 (liquidation bankruptcy), WIN's assets would be sold off and WIN ceases to be a legal operating entity. The lease with UNIT would be voided and UNIT would then have to go out and re-lease the assets to a new operator.
WIN's first quarter numbers appear to indicate that their revenue declines are stabilizing and that the worst may be behind them- at least in the near-term. Adjusted total revenues in the first quarter were down 4.6%. That is a significant improvement from the 8% decline the year before. While not stellar and still losing money, they are headed in the right direction. In the meantime, they are shedding a significant amount of costs while hoarding money to pay down debt after they eliminated their dividend last year.
WINs balance sheet profile, while still weak, has room to breathe with no near-term maturities. Their first debt maturities are not until 2020 but is quite large at $1.5 billion (with $500 million as unsecured notes and $1 billion of revolving credit).
WIN Management is in the process of selling assets in order to reduce debt loans and move to an asset-light business model. In the meantime, should they show continued operational improvement including OIBDAR growth and positive free cash flow growth (2018 guidance is calling for $165 million in adjusted free cash), they should not have a problem rolling their debt.
In our prior analysis, we saw the possibility of rent reductions or outright bankruptcy in the near term as a low probability. We concluded:
WIN cannot force UNIT to accept a rent reduction on its master lease agreement. In fact, no legal entity can force UNIT to accept inferior terms than the ones already specified. Only UNIT can choose to accept a rent reduction in a Chapter 11 situation.
In Chapter 7, it may be forced to accept a lease reduction at which case it could seek out other lessors for the assets. However, WIN has spent $300 million upgrading UNIT's assets since the start of the lease (at no cost to Uniti), which should improve the re-lease rate. Furthermore, fiber assets are increasing in demand due to 5G, as evidenced by decreasing cap rates for fiber transactions. So, a lease that was above market when it was signed two years ago may no longer be above market by the time a theoretical bankruptcy auction was concluded. UNIT management noted that the 0.5% annual escalators in the lease are slightly below the industry standard of 1%, so a re-lease could actually have a higher escalator.
While we think the chances of a lease reduction are fairly low, and an outright bankruptcy is even more remote for Windstream, though we must entertain such scenarios as plausible. We think we have laid out the case that, as a worst case scenario, the market is implying a 36% cut to UNIT's dividend payment given the current yield on the shares and where the yield was just a few months ago before Windstream's latest bout of pain started.
While it remains a higher-risk, higher-yielding stock, the current market-implied discount of the shares remains a compelling risk-return at these levels. We think the market is selling based on the uncertainty and the minimal Street coverage helps to create some added risk.
The prospect of WIN filing for bankruptcy at some point in the future is not gone but it is at least two years out. However, so much can happen between now and when that prospect starts to occur.
The Long-Term Strategy of the Business Is Being Ignored
With all the hype of the Windstream bankruptcy and the lawsuit surrounding it, the thesis on why to own the shares has been lost. This is a long-term play predicated on strong and consistent management executing on their strategy. They have the industry and the playbook and so long as they do not make any missteps nor have additional troubles from WIN, the payoff should be handsome.
The business has a wide moat and we believe will be a substantially profitable business. The tower business has incremental gross margins of approximately 100%. The fiber business has incremental gross margins between 70% and 90% and the leasing segment above 90%. Incremental yields in the tower and leasing business are near 100%. With significant leasing capacity and veryattractive incremental yields, we could be talking about a massively profitable business down the road, especially as 5G rolls out.
The long-term home run is on the predication that 5G takes a massive amount of share from land-based internet. In other words, consumers shift their internet habits significantly from surfing the web on a wifi-based internet protocol to a cellular-based one. If that indeed plays out, look for the tower and data providers like UNITI to be substantially more profitable. We may even here about cord-cutting in relation to modems and internet service from cable and DSL companies in favor of simply using existing cellular plans for internet access as 5G will allow for streaming without buffering.
Buying CenturyLink's Dark Fiber IRUs
On May 10th, UNIT announced (in conjunction with first quarter results) their acquisition of the strategic fiber portfolio from CenturyLink (CTL) as well as an anchor tenant lease. UNIT gets a fiber portfolio of 30 long-haul intercity dark fiber routes totaling 11K miles and 270K strand miles.
Dark fiber is an unused or "dark" network of cabling, switches and repeaters. It is a reference to fiber optic cable where data is transported by passing light through the cable. When no data is traveling through it, there is no light and is thus, dark.
Here is a summation by interoute which is germane to gaining the background of the industry:
When fibre optic cables are laid down, many companies will, in order to future-proof their networks from exponential data growth, overestimate the amount of infrastructure and cabling required. This overestimation coupled with technical advances in the way in which data is packaged means that many optical fibre networks have extra capacity that is not being used. As a result, Dark Fibre networks have developed to take advantage of this extra capacity.
The term 'Dark Fibre' has now evolved to encompass the practice of leasing 'dark' fibre optic cables from network providers and operators. A client will lease unused strands of 'dark' fibre optic cable to create their own privately-operated optical fibre network rather than just leasing bandwidth. The Dark Fibre network is separate from the main network and is controlled by the client rather than the network provider.
UNIT noted in the conference call that they already have a Fortune 100 company lined up for 11% of the strand miles. Management expects to have more over time, with some of it as early as this year.
The supply of intercity dark fiber has declined significantly in the last two decades following the dot-com boom. As ISPs have consolidated through mergers investment in new supply has fallen. In addition, there has been some reluctance to add new lines in order to manage overall supply and pricing. This is an advantage for UNIT who can now lease their lines at opportunistic pricing.
Fiber remains the growth engine of the firm in the form of adjusted EBITDA though the Towers group is larger but less profitable.
They also acquired fiber assets from TelePacific Corp. (TPx) in early March for $95 million adding 650 route miles in California, Texas, Massachusetts, and Nevada. Concurrently with the deal, UNIT and TPx entered into a triple-net lease (with TPx paying UNIT) at an undisclosed rate for an initial term of 15 years and annual escalators.
Overall, the merging of the first-quarter results with the announcement of the CenturyLink acquisition is no accident. It reinforces the idea that UNIT is becoming less dependent on WIN and their current issues. Adding the new CenturyLink assets moves them away from WIN faster. Non-WIN revenue sources are now 34%, which is a substantial improvement from just a couple of years ago. Management noted that they believe that a year from now, WIN revenue will be less than half of the total.
They were asked this on the conference call:
Hi, guys. Thank you for taking the questions. Just two, if I could, one on the M&A pipeline. I think last quarter you had talked about getting diversification or targeting revenues sort of ex-Windstream at about 50% in the next 12 to 18 months. TPx and the CenturyLink deal appear to sort of help you out by about 4%.
But I'm wondering, is that still sort of the target in the next 12 to 18 months and what's the path to get you there? Is it several larger deals, is it multiple smaller deals? So if we can get any sort of updated color there.
And then secondly, you mentioned sort of increasing guidance. One of the components to increasing guidance was additional lease-up at Uniti Leasing. And I'm wondering is that referencing the TPx or CenturyLink properties or is this also additional lease up you're seeing on the sort of - assets held at the Windstream lease? Thanks.
Hi, Matt. It's Kenny. Thanks for the questions. I'll take the first one and then Mark can take the second one. In terms of the 50% goal that we have given for midyear 2019, we still feel good about it. And we don't just use that number and give that time period loosely. We really have put some thought into it just like we have in the past. I think we set goals around achieving diversification levels in the past and we've actually achieved those and think we'll achieve this one.
And to give you a little bit of color on how we arrive at that and to your - directly to your question about are these smaller deals or larger deals or some combination? We really do look at our funnel and look at specific opportunities that we have in the funnel. We're not speculating about things on the comb [ph]. We're really including opportunities that are in our funnel where we're having conversations with counterparties, and we probably weigh the success of those various opportunities, we probably look at the valuations of those opportunities, the competitive landscape of those opportunities. And we overlay with that our cost to capital, what we think our cost to capital will be over time.
The company continues to evolve as the chart below shows. They now have a very large network that is growing by acquisitions and their dark fiber to DTFF strategy.
The firm has three segments: fiber, leasing, and towers. The leasing segment is by far the largest but they are steadily adding new assets and capabilities to the others to create a full spectrum strategy.
The company reported their first-quarter results in early May. The highlights of the report are as follows:
- Revenue rose 2% to $247 million with consolidated adjusted EBITDA of $197 million.
- AFFO per share was $0.62, which compares to the quarterly dividend of $0.60.
- There was a slight net loss of one cent per share including a $3.9 million unrealized non-cash gain.
- Management expects fiber margins to ramp up during the rest of 2018 "reflecting the high loading of certain disconnects and investments in market expansions in the first quarter."
- Maintenance capex is 2.2% of revenues or $1.5 million compared to total AFFO of $67.6 million.
- Capex was $30.8 million in UNIT Fiber of which roughly 60% was for their major dark fiber and small cell deployment projects.
- The company ended the quarter with 710 total towers with 253 in the U.S. and 457 in Latin America.
The shares are no longer in the bargain basement after rising 55%. We do not believe they are overvalued but simply fairly valued. We approach the valuation from the aspect of a credit investor seeing if the current yield is compensating us adequately for the risks.
From nearly all valuation metrics, UNIT was severely undervalued nine months ago trading at dirt-cheap levels. But those models simply do not incorporate the potential, even if low, of the cessation of the WIN rent payments. The probability of a bankruptcy, again while low, still exists as the trial between WIN and Aurelius has yet to conclude. We should know for sure in less than 2 months.
The movement in the share price in the last nine months provides another lever in their strategy. For one, it means the market sees the stock as being less risky than it was, and that the Aurelius lawsuit and WIN bankruptcy were overestimated. Second, should the share price continue to rise and lift above $25 or even back to $30, they will be able to again use equity financing for their acquisitions. This could create a virtuous feedback loop whereby the more acquisitions they conduct, even if they are not accretive to equity shareholders, diversifies them away from WIN faster further reducing their single-tenant risks.
It would also allow them to limit the amount of debt issuance they must use in addition to the amount of interest paid. Already they are forced to pay higher interest costs simply because rates have risen since last year, both on the long end and the short end. Their revolving credit facility is based on libor, which has risen sharply in the last year thanks to the Fed's actions. Their debt issuance has yet felt the effects of the higher rates on the long end but they do have debt maturities for another several years.
So how do you value UNIT shares?
We tend to value these high dividend equity plays from a credit analyst point-of-view. The likelihood of dividend growth, at least in the next 2 years, is fairly low. Thus, the shares are very like a junk bond trading well below par. In other words, nine months ago we saw the bonds trading too cheaply compared to the risks and the reward more than worth it.
The dividend is fairly safe, with the $0.60 payout covered, albeit only slightly, by AFFO. We still think the shares are trading below par but the price gap has definitely closed a bunch since September.
Again, looking at the shares from a credit perspective, the risk of the shares are B/B-. The effective yield of the ICE BofAML U.S. High Yield B Index is 6.32%, up from 5.43% last October. The spread of the index is 351 bps which is in the lower end of the channel range for the last 18 months. That is near the post-recession tights. If we use an average spread of 550 bps over treasuries for similar like debt, the yield would be 9.25%.
Below is the dividend yield of the shares since IPO:
You can see from the chart above where the WIN "issues" started to affect the price of UNIT. The yield on the shares was approximately 9% when the contagion from WIN began. Today, they are at 10.7%, down sharply from a nine months ago when they were well above 15% but still higher than they were before the WIN problems.
We find it doubtful that they get back to that 9% yield in the near-term for two reasons:
- The overhang from the WIN potential bankruptcy is likely to loom for quite some time, possibly years. The issue with WIN is not likely gone but simply partially mitigated. WIN won the court case with Aurelius but it is under appeal and likely to conclude in a couple of months. Should that case be ruled also in WIN's favor, we will likely see further price appreciation and yield decline. But again, the risk of WIN bankruptcy is still hanging like a sword of Damocles above UNIT. The market realizes that potential now so a full restoration to a 9% yield is unlikely until fully resolved.
- The second reason would be higher interest rates in general. The yield peak coincided with a interim nadir in rates in September. At the time, the 10-year was trading around 2.10% and has since climbed ~100 bps before backing off slightly in the last couple of weeks. The spread we need above that rate has declined but that is offset by the higher natural rate in general. In other words, while the risk of UNIT has declined somewhat in the last nine months requiring a smaller spread above the risk-free rate, the rate itself has risen.
At the current 10.7% (or 10.4% before the drop on Friday, June 15), the shares are probably within spitting distance of fair value. We estimate that fair value around $23.50-$24.00. At $22.37, ($22.94 on Thursday June 14), the shares are only slightly undervalued. Be mindful that the ex-dividend date is June 29th so selling now eliminates that dividend payment scheduled for July 13th.
We have an overweight position to the shares so here are some possible mitigants to that:
- Set a limit order at a price that we would be comfortable selling. That would likely be around $23.50 for our first block of shares (around 0.5%-0.75% of the allocation). Then we would stagger another limit above that of around the same size, likely around $24.00-$24.15. And so on until we knocked the position down close to 2%.
- The second avenue is to sell a covered call on the shares. August 22.50 strike calls (if the shares end Aug. 17th above $22.50, you agree to sell them for $22.50) sell for $1.10 meaning our gross of commission selling price would be $23.60.
Shares of UNIT have broken away from WINs downward spiral. Though WIN has stabilized, helping to support UNITs share price, UNIT itself is doing what it can to both diversify away from WINs revenue stream and grow AFFO. The first-quarter results were "OK," but much of their recent strategic actions have yet to start contributing. We should start to see some moderate AFFO growth from them in the back half of this year.
In the meantime, we would recommend trimming the overweight to UNIT here through one of the means noted above - either an outright sale or through an options play. We are close to fair value and given that lack of a margin of safety, the overweight (above 2% allocation) no longer makes sense. However, be cognizant of the ex-dividend date coming up in a couple of weeks to ensure you receive it.
For those without the overweight, you must make a decision whether you want to simply hold for the dividend and ride the waves on price, or trim/sell in order to move onto something else (some possible buys below). The yield is a higher-risk, higher-return potential which we remarked about above. For those highly risk averse, it may be a good time to de-risk your portfolio a bit and sell the shares in order to acquire something a bit safer.
- Landmark Infrastructure Partners (LMRK), Yield 10.9%
- New Residential Investment (NRZ), Yield 11%
- Omega Healthcare (OHI), Yield 8.32%
- KIMCO Realty (KIM), Yield 6.69%
- Simon Property Group (SPG), Yield 4.50%
- Stag Industrial (STAG), Yield 5.35%
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