A new tax management strategy has just opened up for telecom players. Windstream (NASDAQ:WIN) recently announced a plan to spin off its fiber, copper, and other telecommunications assets into a REIT. Until now, telecommunications companies have not considered the possibility of organizing their fixed assets as a REIT.
In the transaction, the Windstream REIT's primary tenant will be Windstream. Windstream will pay lease payments to Windstream REIT, which will distribute lease payments to shareholders in the form of dividends. The transaction will deleverage Windstream, and leverage the Windstream REIT. The Windstream REIT will raise about $3.5 billion in new debt to repay Windstream's existing debt. Windstream will then have stronger cash flows and more financial flexibility to grow in the future.
The REIT structures' primary advantage over the traditional corporate model is tax savings. REITS are generally exempt from taxation at the trust (business) level as long as they pay out 90% or more of their profits as dividends.
Tapping Financial Markets
The REIT structure allows telecommunications businesses to more easily access financial markets. REITs typically have stable cash flows from long-term lease agreements with tenants. These stable cash flows allow the company to generate additional capital through leverage. Easy access to debt markets will allow telecommunication businesses to grow more quickly.
Additionally, REITs also raise capital through equity offerings. REITs raise money in this way by financing growth through share dilution. This dilution does not reduce unitholders' income, as long as the projects in which the REIT invests in are of the same or higher quality as current projects. The advantage to the telecommunication industry is that they can split their business into two separate parts; a REIT business composed of costly fixed assets that generates revenue through its parent/operating company. The REIT portion of the business can better finance growth through share issuance and debt issuance, while the parent company can focus on acquiring customers and managing the direction of future investments in telecommunications.
Will The IRS Allow It?
The most exciting point of Windstream's announcement is:
Windstream has received a private letter ruling from the Internal Revenue Service relating to certain tax matters regarding the tax-free nature of the spinoff and the qualification of the spunoff entity's assets as real property for REIT purposes.
The new telecommunications REIT structure has already received a favorable private letter ruling from the IRS. This may be because Windstream is relatively small compared to the giants in the telecom industry. Windstream's market cap is only about $7 billion, which is tiny compared to industry giants AT&T (NYSE:T) with a market cap of $190 billion, and Verizon (NYSE:VZ) with a market cap of $215 billion.
Even with the small size of Windstream, it is a positive sign that the business has received a favorable positive private letter ruling from the IRS. When the deal closes, there will be precedence for Telecom REITs to organize similarly to Windstream.
The Telecom industry has a large lobby. In 2013, the telecom industry spent almost $55 million on lobbying. For an idea of scale, that is $3 million less than the auto industry spent on advertising in 2013. So why does lobbying matter? The more the telecommunication industry spends on lobbying, the higher the likelihood that larger companies such as AT&T and Verizon will be able to organize REITs in a similar fashion as Windstream.
This is not a political article, and is not intended to discuss whether lobbying is favorable or unfavorable, or right or wrong. Government and private business exist together in the competitive landscape, and lobbying is one way to influence the power of government to provide favorable operating environments for various industries.
AT&T Up On Windstream News
AT&T stock rose about 2.6% after hours on July 29th due to Windstream's REIT announcement. If AT&T organized in a similar fashion as Windstream, it would create an extremely large REIT. AT&T has over $114 billion in property plant and equipment assets on its balance sheet. The company's REIT would control the majority of these assets. AT&T would pay lease payments to the REIT company at an agreed upon amount. If the company follows Windstream's lead, it will pay approximately 75% of cash flow to its REIT company. This would give the REIT revenues in the $25 billion per year range. The majority of AT&T's market capitalization would go to the new REIT, while a (presumably faster growing) stub company would be left.
The entire Telecommunications industry is up after favorable news from Windstream. Even if AT&T is unable to convert its fixed assets into a REIT format, the company makes a solid investment due to its high yield and stability. AT&T compares favorably to other businesses with a long history of dividend payments without a reduction based on the 8 Rules of Dividend Investing, which compares dividend growth stocks to each other based on several quantitative data points including growth rate, yield, volatility, and payout ratio. AT&T is ranked in the Top 20 due to its low volatility resulting from stable cash flows and its high dividend yield.
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