|Shares Out. (in M):||193||P/E||0||0|
|Market Cap (in $M):||1,242||P/FCF||0||0|
|Net Debt (in $M):||4,868||EBIT||0||0|
|TEV (in $M):||6,110||TEV/EBIT||0||0|
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Windstream filed for chapter 11 bankruptcy on Feb 25, 2019 after losing the lawsuit brought by Aurelius.
On July 25, 2019, Windstream filed a complaint that the master lease is not a true lease and should be treated as secured financing.
Rejecting the master lease with Uniti is impossible as the network is mission-critical to Windstream’s operation. Furthermore, in some rural areas, Windstream serves as the only provider where closures require regulatory approval which will not be granted (i.e. calls to 911). Windstream is current on lease payment. The master lease represents more than 80% of Uniti's adjusted EBITDA
Why does this opportunity exist?
The valuation is depressed because investors fear the lease would be recharacterized as a loan and Uniti would become a lender with significant worse recoveries as opposed to being a lessor.
My thesis is that Windstream’s recharacterization attempt will fail. As the uncertainty surrounding the master lease subdues, and with the eventual legal outcome favoring Uniti, the stock would re-rate.
The analysis will focus on the lease recharacterization claim because this is what drives the stock. The worst case scenario for Uniti stockholder is if the lease is deemed a loan. Even a “close call” would provide leverage for Windstream to renegotiate the lease.
Courts generally look past the labels in the lease and examine the intent of the parties and apply two tests focused on the economic substance of the transaction: a “residual factors” test and an “economic realities” test.
It is well-established in the Second Circuit that an agreement styled as a lease is strongly presumed to be a true lease unless and until it is proven, not merely alleged, to be something else
Residual Factors Test
The first part of the test looks at whether the lessee may terminate the agreement during its term. The second part looks at residual value. If the lessee cannot terminate the lease during its term and any one of the residual value factors is present, the transaction is a sale without consideration of any other facts and circumstances.
The master lease passes the first part is it is non-cancelable by Windstream.
The original lease term is equal or greater than the remaining economic life. Windstream claims that the remaining useful life was going to be consumed during the initial 15-year lease term. The economic life, as determined by the independent appraiser E&Y at the time of the transaction, was 28 years and the lease term was 15 years. E&Y valuation will stand because:
E&Y was the independent appraisal hired by Windstream
Both parties, Uniti and Windstream accepted the report, and did not raise any objections to the report until Windstream tries to recharacterize the lease.
Windstream has made multiple statements, including in earnings calls, in presentations with regulators, and in sworn testimonies in the Aurelius trial that, either explicitly or implicitly that the valuation by E&Y is deemed accurate.
Windstream’s argument for a shorter useful is based on unsubstantiated claims that the useful life of copper wire is overstated due to advances in new technology that renders copper obsolete.
This claim is not true as many fiber connections today still require copper at the endpoint. This is very much like claiming a car will be obsolete because its tires will run out in 3 years.
The test is based on facts at the time the agreement was made in 2015. Assumptions made in 2019, even if correct, is not applicable in this test. The fact remains that in 2015, the estimated useful life was 28 years.
Statements made by then Windstream CFO Bob Gunderman contradicts the assertion that copper is obsolete in one of his testimony under oath in front of the Kentucky Public Service Commission, “Of course it is impossible to predict what technological and economic changes may have occurred by that time; it is at least theoretically possible that, by 2050, the Subject Assets could be considered obsolete and have little practical value. It is much more likely, however, that there will continue to be demand for some kind of telecommunications capabilities delivered to homes and businesses over fixed transmission facilities, as there has been since telephone technology was developed in the late 19th century, even though the nature of the facilities and the services they enable will probably continue to change.”
The lessee is bound to renew the lease for the remaining economic life or is bound to become the owner. Windstream’s claim: Even Windstream’s Tenant Capital Improvements (“TCIs”)—which are forfeited to Uniti under the Uniti Arrangement—have not been enough to leave any material remaining economic life in the “leased” networks. Windstream’s forced investments for Uniti’s benefit chains Windstream to the Master Lease, making a failure to renew at the end of the term economically irrational. This claim is absurd because:
Windstream equates accounting depreciation schedule with economic useful life. Accounting depreciation schedule does not equal economic useful life. It is well established (there are many lease recharacterization cases about equipment leases and aircraft leases. For instance, aircrafts are depreciated at 25 year useful life for accounting purposes but many aircrafts operate in excess of 25 years) that economic useful life is vastly different from GAAP depreciation schedule. Windstream has not produced other evidence supporting its claim. The burden of proof is on Windstream, the challenger of the lease.
Windstream has spent more than $330mm (40% of total TCI spent) on copper investments since the lease commenced in April 2015. If Windstream believed copper is already obsolete at the time of the transaction, then the subsequent spending is merely maintenance expenditure, not capital investment.
Using Windstream’s logic, the assets will be worthless before its renewal. Thus the claim that Windstream is chained to the master lease is flawed as it does not make economic sense to renew.
The lease does not obligate Windstream to spend TCI. All TCI spending are at Windstream’s discretion.
Windstream is not bound to renew the lease. It is free to build new networks infrastructure.
Lessee has to option to renew for no additional consideration or for nominal consideration, or Lessee has to option to become the owner for no additional consideration or for nominal consideration
There is no option for Windstream to acquire the assets for nominal consideration. Renewal lease rate is based on market rents.
Based on the above, the master lease passes the residual factor test.
Economic Realities Test
Current law also includes a second level of analysis that is designed to evaluate the facts of each transaction to determine whether the transaction is a lease or disguised financing. In evaluating the “economic reality” of the transaction, courts will look at a number of factors, with no one factor controlling:
whether the purchase option is nominal
The master lease has no purchase option. The renewal is at market rates subject to independent appraisal.
whether the lessee is required to make aggregate rental payments having a present value equaling or exceeding the original cost of the leased property.
Based on E&Y’s valuation, at the time of transaction, the asset is worth $7.45B. In Windstream’s 2015 annual report note 5, the PV of the initial lease, based on Windstream’s incremental borrowing rate at the time, was $5.1B, or 68.5% of original cost.
whether the lease term covers the total useful life of the equipment.
The lease term is 15 years, well short of the estimated useful life of 28 years. Thus, Uniti retains a meaningful residual interest in the leased property.
whether rent payments are payments of principal and interest rather than mere compensation for the use of the property; Windstream claims neither side during negotiations wanted Tenant Capital Improvements to be included in the basis for renewal rent. It is paying twice for the same Tenant Capital Improvements—first in financing the Improvement and then again once the TCIs are valued as part of the bundle of assets being priced for renewal.
The fact that TCI spent by Windstream would earn a return at renewal for Uniti disproves the claim that rent payments are based on principal and interest.
The rent does not adjust on a sporadic basis. The rent escalators are fixed at 0.5% starting in year 4. If rent adjusts to some external benchmark, the transaction will appear more like a financing with adjustable interest.
whether the lessee is required to purchase the property upon the occurrence of certain events or the lease provides the lessee with an option to purchase the assets for nominal or minimal consideration;
There is no purchase option or asset transfer at the end of the lease term.
whether the agreement transfers to the lessee the risks and obligations of ownership — such as the responsibility for payment of property taxes, maintenance and repair of the property, and maintenance of insurance — that normally are possessed by the lessor;
This factor is of little probative value in light of the widespread use of triple-net leases, whereby the landlord passes most, if not all, of these obligations through to its tenant. However, certain obligations, for instance the guarantee of residual value, may push the boundaries of what a tenant would typically encounter in a triple net lease. There is no guarantee of residual value in the lease.
the ability of the lessor to market the equipment at the end of the lease term; Windstream claims that should Windstream exit the lease, it will be challenging for Uniti to find a replacement tenant for networks tailor-made for Windstream.
Although the network is designed specifically for Windstream, the equipment and technology (network gear, copper and fiber lines) are standardized. The network can be modified for use by another operator.
whether the transaction was structured as a lease instead of a loan to secure tax or other benefits;
There were additional benefits for Windstream to structure this as a true lease.
The transaction shifted income to Uniti REIT which does not pay tax. Both companies are controlled by the same party at the time of the transaction. Uniti cannot obtain IRS approval for REIT status if the lease is not a true lease. To obtain the IRS ruling, Windstream made numerous presentations to the IRS that implied the lease is a true lease. Interest income from loans does not qualify for “rent”.
The spin-off is structured as a lease, not a loan, to avoid breaking debt covenants, as demonstrated in the Aurelius case.
Windstream received economic benefits in receiving Uniti common stock. Uniti traded at a materially higher multiple than Windstream because the master lease was perceived by the investor community as a true lease. Windstream had to believe the transaction had the financial characteristics of a true lease in order to market the financial securities of Uniti (then known as CSAL) to the capital market. To believe otherwise means Windstream intentionally broke its debt covenants.
Windstream’s Attempt to Recharacterize the Master Lease will Fail
For the foregoing reasons, I believe the court will hold that Windstream has not sustained its burden of proof to establish that the transaction is not a true lease. The economic terms are that Uniti will retain a meaningful residual interest at the end of the lease term in 2030.
My analysis is incorrect. Windstream has a strong enough case to force Uniti to re-negotiate the master lease at less favorable economics.
As of 3Q19, Windstream generated $1.77B of operating income before D&A and rent in the latest 12 months. Rent coverage for the master lease is higher than 2.7x. The rent payment is higher priority than Windstream’s capex spending because most of capex goes to the leased asset.
I base my valuation multiple on the expectation that the challenge for recharacterization would fail. Given the weak legal merit, Windstream will soften its stance and settle with Uniti. I do not expect any lease reduction given the criticalness of the leased asset to Windstream operations.
My base case price target of $10.9 (70% upside from $6.43) is based on 9x unlevered FCF or 8.5x 2019 EBITDA (mid-pt of guidance) which represents a steep discount to other infrastructure REITs (CORR and LMRK at 10.5x and 13.5x EBITDA respectively).
After Windstream exit bankruptcy, which I believe will happen within 2 years, the stock should re-rate further to 10x – 12x AFFO, or $16 – $19/share.
The trial for the lease recharacterization is scheduled in March 2020. I expect a favorable settlement will be reached before trial.
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