Windstream Retains Neutral Thesis As Performance Stays Poor In Second Quarter

Aug.25.14 | About: Windstream Holdings, (WIN)

Summary

Revenues for consumer and business segments declined, contributing 84% to total revenues.

Loss of subscribers in all major segments was worrying sign for investors.

REIT structure proposed by management will reduce taxes, and savings could be diverted to network enhancement.

Windstream Holdings, Inc (NASDAQ:WIN) is a local exchange carrier, which provides voice, Internet, data and other related services to residential and business customers across 16 states. I reiterate my neutral stance because the company continued its weak financial performance in the second quarter. Furthermore, I also believe the company is currently overvalued based on the Enterprise-to-EBITDA multiple. However, WIN's creativity in spinning off its assets in a REIT structure will enable the company to reduce its taxes and enhance its EPS and free cash flows.

Financial Performance

The company's major revenue stream comes from the business and consumer segments, which contribute around 62% and 22% respectively. Both these segments failed to perform well in the second quarter. Business revenues decline by 1.2% YoY in the last quarter. Within the business segment, nearly 40% of revenues come from small businesses. The small business locations are declining by 9.8% YoY, which overshadowed growth of 2.9% YoY in enterprise locations. The large decrease in small business locations is due to aggressive competition by cable companies in a small business space.

In the consumer segment, WIN has shown disappointed results. It reported a loss of 3.4% YoY and 5% YoY in high speed internet and digital TV customers. These two segments remain a major growth driver for its peer companies, CenturyLink (NYSE:CTL) and Frontier Communication (NYSE:FTR). In the second quarter, CTL added 16K Prism TV subscribers and FTR added 27.5K broadband subscribers. The company has finished up-extending its network to 75K new households but it did not accompany subscriber growth; WIN lost 16.6K subscribers in 2Q.

Another important thing for investors is that the company has raised prices for the consumer and enterprise business. It has helped the company increase its ARPU and the company is expected to benefit from this strategy in the second half of the year. However, I believe it's not a good strategy, as it will impact subscriber metrics because of high competition in the market. This decline is already visible in the consumer segment. I expect that enterprise will show similar results in the third quarter, as the price increase came slightly late in the last quarter.

REIT Structure

WIN's management has proposed a REIT structure in which it will spin off its copper and fiber lines and other related assets to a separate REIT entity. The company would then lease back those assets for further use. The expected lease payment is expected to be $650 million. The transaction is expected to complete in the first month of 2015. The basic purpose of re-allocating its assets is to reduce taxes as REITs are exempt from taxes. Importantly, the IRS has given its blessings, but companies need to get approval from ten state regulators. Furthermore, the management seems to be very confident after initial talks with some of the state regulators.

Jeff Gardner, the CEO of the company, is reported to have said in the earnings call, "This transaction will unlock significant value and result in lower leverage for Windstream. In addition it will enable increased capital investments to strengthen Windstream's network and provide faster broadband speeds and enhance services to our customers."

The company expects to direct tax savings to its network building. I believe the company should have made investments in its network a long time back. It should have given up its dividend-centric strategy, much like its competitors CTL and WIN have done in the past. Currently, WIN's dividends payout and leverage are very high, which is forcing the company to adopt the REIT structure as it would help reduce the pressure on its free cash, which in turn could help to improve the network performance of the company. However, I believe the REIT structure is not a done deal and investors should wait until all the regulatory issues are settled.

Valuations

I have reduced my estimates for the expected 2015 EBITDA to $2190 million from $2255 million. The reduction in the expected EBITDA is driven by the weak corporate performance and limited growth opportunity. So, I am revising my price target to $7.25, which is based on the 6x expected 2015 EV/EBITDA, as shown in the table below. The figures for total debt and shares outstanding have been taken from Yahoo Finance. The company is overvalued as WIN is currently trading at $11.25 per share. I am expecting a pull back.

EV/EBITDA multiple

Expected 2015 EBITDA

Enterprise Value

6x

$2190 million

$13,140 million

Click to enlarge

Enterprise value=$13,140 million

Total Debt= $8,770 million

Total Value to firm - Total Debt = Total Equity value

$13,140- $8,700= $4,370 million

Share Outstanding = 602.7 million

Target Price = Total Equity Value/Share Outstanding

$7.25 = $4,370/602.7

Final Words

The company continued its poor performance in the second quarter. Revenues for both the consumer and business segments declined, as they contributed around 84% to total revenues. The loss of subscribers in all major segments was a worrying sign for investors. However, the REIT structure proposed by the management will reduce taxes, and savings could be diverted to network enhancement.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.