Uniti Group: Dark Fiber Lights The Way In Legal Abyss

Jan. 25, 2018 12:34 PM ETUniti Group Inc. (UNIT)98 Comments
Joshua Mou profile picture
Joshua Mou
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Summary

  • Uniti is positioned to turn Dark Fiber Cables into revenue growth.
  • Uniti's business is still highly concentrated with Windstream, which is battling legal challenges from an activist investor.
  • Uniti is a profitable growth company with a high dividend at the current stock price.
  • Due to legal risk, only attentive and studious investors should buy UNIT.

Uniti Group, Inc. (NASDAQ:UNIT) is a Real Estate Investment Trust or REIT that specializes in owning and leasing out telecommunications assets. Uniti is one of the newer players in the industry and, despite its relatively small size, it has some attributes that make it interesting for investors.

The Business

To understand how a company like Uniti fits into the business landscape, it is helpful to first point out one of the big challenges of the telecommunications industry. The infrastructure supporting the massive growth of smartphones, video streaming, and communications is very expensive to deploy. Companies such as Windstream (WIN), Verizon (VZ), and AT&T (T) need to spend large amounts of money every year because there is a continuous need to expand and to upgrade their services. While a capital-intensive industry has the advantage of high barriers to competition, the constant need for capital throttles the pace of growth.

Uniti’s business model is to own assets that telecommunications companies have traditionally owned—fiber optic cable and cell towers. Instead of a wireless carrier tying up lots of their cash on cell towers and fiber networks, Uniti can build the expensive infrastructure while the carrier pays rent to Uniti for the use of that asset. Or, Uniti can buy a carrier’s existing assets and rent it back to the carrier. The telecom benefits because it does not have to spend money on those expensive assets or because it can get cash for those assets that it already owns. But, the telecom still gets to operate and control those assets as it always has. In return, Uniti gets to collect reliable streams of income from valuable assets. The industry seems to approve of this arrangement, as Uniti has continued to book contracts with all four national wireless carriers, many regional carriers, over 100 colleges and universities, many K-12 schools, and local enterprises.

There is tremendous growth in wireless data usage, driven by mobile video, Internet of Things, machine-to-machine communication, autonomous vehicles, utilization of consumer information, and interconnected cities (Figure 1).

Figure 1: Source Uniti_Group_Inc_-_Citi_2018_Global_TMT_West_Conference_-_Final_A-03.pdf

This growth of data needs to be transferred quickly and reliably, and this is where Uniti fits in.

Figure 2: Telecommunications Diagram (Joshua Mou January 2018)

Wireless carriers have core networks that need to be connected to cell towers or local networks; the connection from their core network to the distribution sites is called Backhaul. Uniti’s backhaul assets are made of fiber, which is a significant upgrade in speed and capacity to prior generations of copper cable backhaul. Uniti’s fiber backhaul transfers data to cell towers, small cell networks and enterprises. Small cell networks are groups of short-range radio antennas but with higher density than cell towers. Enterprises are typically businesses. Uniti also serves government entities and schools. Uniti also owns some of their own cell towers and small cell networks.

Uniti Business Divisions

Figure 3: Data Source UnitiGroup_10Q_20171102.pdf

Uniti Leasing acquires communication infrastructure, which they lease back to the seller. This division comprises about 70% of company revenues, $172 Million in 3Q17. This division is comprised almost entirely of a single contract with Windstream, a provider of residential broadband internet, cable TV, and business communication services. This division is expected to have low but stable growth of around 0.5%, based on rent escalators in the contract. This is a high-margin business, and it provides stable cash flow. Because carriers have a constant need for capital, Uniti sees opportunity to grow this division through future acquisitions.

Uniti Fiber provides fiber backhaul infrastructure to cell sites and small cell networks. Uniti Fiber division has 1.3 million miles of fiber strand to rent to customers—separate from another 3 million miles of fiber strand owned in the Leasing division. About 460,000 strand miles are Dark Fiber, which is unused fiber strand. Dark Fiber represents potential revenue. Fiber reported $66 Million in revenue or 27% of total revenue according to the 3Q17 Quarterly Report linked in Figure 3. The company expects the Fiber division to provide significant near-term growth. In fact, 80% of current backlog is for future dark fiber leases. This division is best positioned to take advantage of the growth in data usage.

Figure 4: Source Uniti Presentation January 9-10, 2018 linked previously.

In Uniti’s recent quarterly presentation and conference call, they revealed a backlog of around $498 million in new fiber contracts that will be activated in the next three years (Figure 4). By my calculations, this backlog is worth about $35-40 million in additional revenue each year over the next 12.8 years. In their 3Q17 Conference Call, the company projects total revenue in 2017 at $913-918 Million, this means that growth from current Fiber backlog would add up to 4% company-wide revenue growth. And, they have more unleased dark fiber to fuel even more growth.

Uniti Towers division owns and leases 652 wireless communication towers in the U.S. and Latin America, including Mexico, Colombia, and Nicaragua. It has over 31 additional tower sites under development. Each tower can be leased to multiple wireless companies. Latin America has many areas that are only using 3G or even 2G connections, which means that there is a great need for more infrastructure to handle future upgrades. In the U.S., many of Uniti’s cell towers supplement the fiber assets that it owns. At this time, Uniti Towers is a very small portion of the business, comprising only 1% of revenues at around $10 million each year. Management does not foresee transformative growth in this division, but adding U.S. cell towers to the portfolio can supplement the fiber division and provide good returns on investment. The tower industry is dominated by a handful of tower-focused companies. But, some wireless carriers still need a few more towers to infill their networks, and these are usually profitable, build-to-suit projects.

Quality Of The Business

Once we understand how Uniti Group works, we need to decide how good of a business it is.

Complexity: It may take investors some time to understand the communications industry and its many interrelated parts. But Uniti’s business is relatively straightforward once one understands its place in the industry. It does not earn money via complex financial derivatives. The demand for its assets can be seen all around us in how many people are using mobile video, how much companies like Google are tracking our activity, and how much we are automating our cities and homes.

Consistency: Uniti signs long-term contracts, often with clauses that slowly increase annual rent. This makes revenue predictable. Uniti’s assets last for a long time without needing significant maintenance. As long as those assets are well placed, then they should produce reliable revenue.

Long-Term Prospects: Uniti makes an excellent argument that there is a significant demand for its dark fiber assets, which would give them a great platform for revenue growth. This is also their best organic source to dilute the share of Windstream business. However, investors need to keep history in mind. The reason that there is so much fiber in existence already is that previous companies built fiber networks for data growth that did not materialize as fast as predicted. Investors need to consider the small chance that fiber demand will be slower to materialize than Uniti predicts.

The majority of Uniti’s business is leasing communications infrastructure to Windstream, and any Uniti investor needs to keep a close eye on a particular lawsuit. There are several articles by SA author Beyond Saving that are must-read material for Uniti investors. Currently, Windstream is under legal attack by an activist investor named Aurelius. Aurelius is a Windstream bondholder that initiated lawsuits designed to bankrupt that company. Theoretically, if Windstream goes bankrupt, the infrastructure that they lease is essential to their business, so they need to keep paying their rent in order to salvage their business. If Windstream goes out of business, then their customers will still demand the services they are currently receiving. Another company would likely see the opportunity take over the business, and that would create demand to continue leasing the assets that Uniti provides. Uniti makes a strong case that their lease with Windstream is secure, even in bankruptcy—see the following powerpoint slide in Figure 5.

Figure 5: Source Uniti January 9-10, 2018 Presentation linked previously.

While Windstream seems poised to fend off the attack from Aurelius and while Uniti seems to have an air-tight lease with Windstream, the often capricious nature of the U.S. legal system introduces a significant risk to such a large portion of business.

Competition: Communication infrastructure such as towers, cable, and fiber networks are expensive to build. This is one reason that wireless companies are leasing infrastructure rather than building or are selling things they have built to free up money they have had tied up in infrastructure. Uniti operates in many Tier 2 and Tier 3 markets, which are smaller markets that have fewer fiber providers, but still have high demand--as discussed in the previously linked 3Q17 conference call. In the case of Windstream’s lease, the lease is long-term and is structured so that Windstream has no incentive to use alternative providers.

Management: Uniti does not have a long operating history to judge the decisions of management, but members of their leadership team all have +15 years of telecommunications experience. They are internally managed, which means that the management is employed by the business as opposed to externally managed with a contracted management group. The biggest benefit of internal management is that management is typically less expensive. Uniti paid $22.1 Million for G&A expenses last quarter, compared to the over $40 Million that an external management group would have been paid under a standard industry fee structure. External management is financially incentivized to grow the size of the business but not the profitability of the business. The one advantage of external management is that they have greater resources to source new business deals, which is good for companies that need to replace a high volume of short-term deals. This advantage is not very useful for Uniti because their business deals usually last 5-20 years. So, for Uniti, internal management is a distinct positive. They have also done a good job structuring their largest business; the Windstream lease is comprehensive in its ability to protect Uniti from catastrophe. They have also avoided some common mistakes such as raising too much debt or selling stock when the stock price is less than the value of the company. In the next few years, investors will be able to examine the returns of investments they have made.

Balance Sheet:

Figure 6: Source Uniti Presentation January 9-10, 2018 as linked previously.

Figure 6 shows that on September 30, 2017, Uniti had $50 million in cash. They also have $590 million borrowing capacity available in a Revolving Credit Facility. They have a total of $4.5 Billion in long-term debt. Their interest expense in 3Q17 was $78.8 Million, which would annualize (3Q17 figure multiplied by four) to $315 million. Their debt carries an average interest rate of 7%. The earliest that any significant debt will be due is not until 2022, which means they have four years before they need to address any of their debt. Their assets are valued at $4.3 Billion.

Value Of The Business

To an investor, Uniti has two things of value. They own telecommunications assets, and they have profits. Their assets are worth $4.3 Billion, but they only control these assets because they hold $4.5 Billion in debt. Therefore, it is difficult to justify valuing the company based on their assets.

REITs such as Uniti report their profits by a term called Adjusted Funds From Operations. Uniti adds up all its quarterly revenue ($242 Million in 3Q17) from their leases and then it subtracts all its expenses ($239 Million) to calculate their net income ($3 Million), like all publicly-traded companies. But, most REIT assets are long-lived real estate, which usually do not depreciate in value or require significant reinvestment. Therefore, REITs add back the depreciation amount to net income to get Funds From Operations (FFO). FFO is the cash produced by the company after all expenses. Uniti makes a further adjustment for non-recurring expenses and revenue to produce Adjusted Funds From Operations or AFFO ($111 Million in 3Q17), which shows what cash flow would be if there were no further changes to the business (Figure 7).

Uniti’s AFFO calculation is a pretty good measure of profitability. If we extrapolate the last quarter AFFO of $111 Million over a one-year period, we get an Annualized AFFO of $444 Million. As of the close of the market on 1/23/18, the current market valuation of the company was $2.9 Billion ($16.42 per share based on 175.4 million shares) The company’s annualized AFFO ($2.52 per share) is a 15% return on Uniti’s share price. Uniti is projected to pay dividends of $420 Million ($2.40 per share) in the next year, which is 95% of their profits (Figure 8).

Because almost all their profits are turned into dividends, investors see most of their return in the form of dividends, which is paid at a rate of 14.5% of the share price. In addition, they have the potential for 3-5% profit growth with just the assets that they already own.

Conclusion

Uniti’s dividend payout is exceedingly high, even for a REIT. Investors need to recognize that the stable leasing business and promising growth opportunities are balanced by the short operating history, concentrated business risk, high dividend payout ratio, and legal risk. Anyone who does not follow and understand the Aurelius-Windstream case should not invest in Uniti. Even those who believe that Windstream and Uniti will prevail in court must recognize the unpredictable nature of the legal system. A series of adverse legal decisions could drastically reduce profits for a year or more, put pressure on debt obligations, discourage potential customers from doing business, and add volatility to the stock price. Anyone who does not have time to monitor Uniti’s progress in utilizing their fiber assets, in diversifying their customer base, in acquiring new assets profitably, and in managing their balance sheet should not invest in the company. However, attentive Uniti investors who are highly confident in the outcome of the Aurelius-Windstream case could be rewarded with high returns for a bet on this promising company.

This article was written by

Joshua Mou profile picture
438 Followers
I started investing in individual stocks in 2008. My investment activities have been exclusively for my personal portfolio. Investment Method:My focus is on companies with predictable profits that sell at prices that allow above average long-term returns. I value companies based on their earnings power. In particular, I value stable earnings and growing earnings for the simple reason that they require less monitoring. As a result, most of my research time is spent trying to predict future earnings. While predictions are always a guess, good companies tend to have a good track record of good earnings, competitive advantages, good managerial execution, and good capital management. Investment research is not hard, but it is tedious. Note that certain industries use certain terms that better measure companies' earnings power in their unique environments--i.e. Funds From Operations for REITs, or Net Investment Income for BDCs.US Stocks provide an inherent advantage to investors. The overall strength of the US economy propels US companies toward increasing earnings growth. As a result, the average investor has a baseline chance of mirroring economic growth. In gambling, the house wins over the long-term due to certain statistical advantages against gamblers. In investing, investors have the long-term advantage of a growing US economy. This advantage is the primary reason that I consider stocks to be a good vehicle for wealth creation. Even the laziest investor has historically performed well just by buying a broad-based US index fund.Certain factors can cause investors to deviate positively or negatively from expected investment returns. Taking unnecessary risk in companies with unclear or unproven earnings is the primary danger that I see. To me, risk comes from the unknown. While risk is unavoidable, I feel that controlling risk is the best way to achieve reasonable investment returns. Investment risk comes from anything that decreases earnings, such as poor capital management, competition, and changes within industry.Many consider stock price fluctuations (beta) to be an element of risk. However, most savvy investors see those fluctuations as opportunity for above-average investment return. Stock prices often deviate drastically from a company's earnings trend, and when stock prices drop they can give investors a chance to purchase very profitable companies at bargain prices. Valuation must always be considered prior to any investment purchase. Paying too much for even a great company will result in mediocre returns. I also measure every potential investment against what I already own. I start with the safest possible investment--US treasury bonds. If I consider any investment that carries more risk, it must have the potential for higher returns than a US treasury bond. Are the earnings as stable as my other investments? Does the price allow a reasonable return and a margin of safety if I am inaccurate in my projections?Dividends are not a primary factor in my decision to purchase an investment. However, dividends, when reinvested, can provide an additional boost to investment returns. Compounded earnings growth is the primary engine for investment returns; dividends add a second engine for additional investment returns. While earnings are the most direct measure of a company's profitability, dividend history is also a good proxy of profitability. Another important attribute of dividends is that an investor can harvest cash without sacrificing assets. A dividend-paying company can continue to pay dividends until its earnings cannot support the dividend. Many strong companies raise their dividends annually, thereby providing protection against inflation.My investing record is not long enough to show if I have superior investing skill. In fact, I have and will make substantial mistakes. However, I have had significant overall gains. Plus, I am constantly amazed at the efforts and ingenuity of business both small and large. The SA community has been tremendously helpful in my investment education. I share my own research through the few articles that I have written for SA in the hopes that others can benefit from my many hours of study. Best wishes to all! Current Long Stock Positions:AAPL-AppleAWLCF-Awilco DrillingBRK.B-Berkshire HathawayCLDT-Chatham Lodging TrustCORR-CorEnergyDIS-DisneyETN-Eaton GILD-Gilead HON-Honeywell HTGC-Hercules Technology Growth Capital KIM-Kimco Realty LUV-Southwest Airlines MAIN-Main Street Capital MPW-Medical Properties Trust NEWT-Newtek Business Services NMFC-New Mountain Finance OHI-Omega Healthcare SBRA-Sabra Health Care SKT-Tanger Factory Outlets STAG-STAG Industrial T-AT&T TGT-Target UNIT-Uniti Group UNP-Union Pacific VTR-Ventas WFC-Wells Fargo WPC-W.P. Carey

Disclosure: I am/we are long UNIT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have held UNIT since November 2017. I will not buy or sell UNIT or its derivatives over the next 72 hours.

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