Uniti And Windstream Debt Downgrade: What It Means

Summary

• Both Uniti and Windstream saw their debt ratings downgraded by Moody's.
• This is the nail in the coffin for Uniti when it comes to traditional financing: growth is uneconomical without extreme inventiveness.
• No clear catalyst is present in the medium term; I see no reason for share prices to appreciate. For total return investors, this doesn't look to be a buy.

I continue to follow the Windstream (WIN)/Uniti (NASDAQ:UNIT) story with interest. In general, I avoid owning equity in companies with likely near-term impairments in the capital structure that are likely to weigh on sentiment. This has consistently made me money on the short side and helped me avoid the proverbial falling knives on long positions. As examples, frequent readers have seen me avoid CBL & Associates (CBL) all the way throughout its collapse or to short companies that were likely to see new pressure on debt ratings (Molina Healthcare (MOH) as a recent example). Both Uniti and Windstream now see more pressure as both firms were downgraded deeper into junk territory on February 28th.

I've maintained that Uniti's price is not going to go anywhere as it stands and that it faces a tough battle in changing market sentiment away from how important Windstream is to long-term health. Much to the dismay of high-yield income investors, I've advocated for a dividend cut in the past to help raise capital, however incremental it might be to diversification and deleveraging efforts. When I penned that article back in September on ex-date, Uniti was essentially trading exactly where it is today. Even including the two payments, investors would have been better off in an S&P 500 index fund since then.

A long-standing comment I've made is that "cheap can often get cheaper". As the company sits today, I challenge investors to think long and hard on what they believe the catalyst is for Uniti to rise between now and 2020. Making matters worse, the company will likely exhaust the capacity on its Revolver in 2018 due to likely further spending. In doing so, will tap out on growth without an inventive approach. Leverage covenants will restrict the company to unsecured debt issuance at that point, and borrowing costs for unsecured notes will be uneconomical to make investments. That's a recipe for dead earnings and dead money until a Windstream bankruptcy brings forth the true test how the master lease will be treated.

Capital Structure, Moody's Downgrades

To close out 2017, Windstream reported operating income before depreciation, amortization, and rent ("OIBDAR") of $2,010mm, down 5.5% from 2016 results. Sales were down at a similar rate. Mid-single digit declines in OIBDAR are expected over the next several years, a natural product of chronic underinvestment by Windstream in the past. While there is little in the way of near-term maturities - management has thus far staved off problems there - most observers believe the company will have problems rolling over its 2020 debt: $775mm on its revolving credit facility coupled with $493mm in outstanding unsecured notes. If it gets past that hurdle, 2021 sees the maturity of $1,193mm in Term Loans. That is a lot of the debt that will need to be refinanced, and lenders are unlikely to be willing to do so in my view. The 2020 notes trade at nearly 15% yield to maturity, well above the 7.75% coupon they were issued at. Windstream cannot roll over this debt at those kinds of rates and survive. Without a massive turnaround in subscriber trends or cost-cutting savings that would reverse the declines in OIBDAR and therefore see sentiment improve, it is unlikely that Windstream survives until 2022.

I don't think anyone can argue that the capital structure of both companies remains fundamentally in very poor shape. Both companies saw downgrades to their debt ratings from Moody's today, and perhaps most importantly, outlook remains negative. As it stands, the market viewpoint of Uniti's debt is always going to be tied to the oscillations in Windstream and its probability of bankruptcy. With the cut to Uniti's unsecured debt rating to Caa2, Uniti debt is now regarded as extremely speculative and is one notch above where debt analysts would view default as "imminent with little prospect for recovery". If debt analysts' view unsecured debt as having little recovery, then the equity would be decidedly worthless. The Global Credit Research Team at Moody's had this to say:

The negative outlook reflects Uniti's tightly-linked credit profile to that of Windstream, which continues to face negative pressure. Despite certain scenarios such as a distressed exchange (DE) or Windstream's acceptance of the master lease within a bankruptcy restructuring not resulting in a default by Uniti, Moody's believes that continued negative results for Windstream will directly impact Uniti's credit profile.

I know exactly where readers' minds are going. The story of the Windstream/Uniti master lease has been beaten to death. I don't believe anyone at this point is unaware of the dependency of Windstream on the network leased from Uniti for its operations, and the indivisible nature of the lease, in theory, must be accepted or rejected in whole in bankruptcy. We all - hopefully - can read investor presentations and master lease agreements. So can shorts, but they still are willing to put capital on the line.

Uniti management has maintained that a bankruptcy court has no authority to change the rent amount or terms. Further, whether the Federal Communications Commission ("FCC") or state regulators would weigh in on a haircut to the lease. Rural areas need telephone access and some sort of infrastructure. That's a given. Bankruptcy comparables in this space are non-existent, and at the end of the day, a private company's margins have to support the cost of doing business. This is all an unknown, and the concept that the master lease is not going to see a haircut under any situation seems illogical to me.

Running Out Of Money?

Uniti continues to throw cash every which way despite its high leverage: the dividend payment, mergers, and acquisitions, capital expenditures. Through Q3 2017, Uniti had generated $338mm in operating cash flow (up year over year in large part due to unsustainable working capital improvement) while spending $294mm on dividends, $846mm on business acquisitions and ground lease purchases, and $111mm on capital expenditures. Despite all of that spending, fiscal 2019 EBITDA is expected to be $820mm according to sell-side consensus: low single digit growth off of the 2017 base. These fiber assets are notoriously expensive to acquire on a cap rate basis, which just doesn't jive with the high cost of capital Uniti endures today. With the dividend eating up all of the available capital, there is no path to deleveraging and cost of equity remains too high to issue stock.

This type of spending is not a sustainable practice. Management likes to highlight available liquidity, and while there is availability on the Revolving Credit Facility to borrow, it is likely that Uniti runs through that capacity in 2018. In putting money on the Revolver, it will be forced to issue unsecured debt for further growth (due to the consolidated secured leverage ratio covenant); unsecured debt will be uneconomical to acquire assets as cost to borrow will exceed the normal cap rates in this sector.

Growth will instead come down to inventive and opaque financing deals, options management has alluded to in the past but has yet executed on in a meaningful way recently: convertible preferreds, sale/leaseback transactions, etc. In my view, there is no way management can raise enough capital at attractive enough terms this way to meet their revenue diversification goal. Management has maintained that they view current cost of capital as "temporary", which I think is an overly optimistic view.

Takeaway

Does Uniti cover its dividend? Yes. Does Uniti have a viable path to grow itself out of its current predicament? In my opinion, no. Cost of capital is too high, and the downgrades by Moody's only solidify that fact. The only way for shareholders to see capital appreciation is for the risk premium (e.g., market-demanded yield) to contract. There is no apparent catalyst for that in my view. The Uniti story is well-known at this point, and the market's cautious outlook is unlikely to change until it is proven right or wrong once a Windstream bankruptcy occurs (an event that I peg the odds at greater than 60% within five years). As many stated early on in this saga, the best way for longs to prove value was to "rip the band-aid" off so to speak. Perhaps counterintuitively, the earlier a Windstream bankruptcy occurs, the quicker the bulls get to prove their thesis correct on the master lease.

If you're a risk-seeking income investor, I can see the appeal here. For me, I still don't see it. I think the base case expectation for Uniti should be the company continuing to trade right where it is now until a catalyst on the Windstream front (positive or negative) makes itself clear. That might be a long wait.

Analyst’s Disclosure: I am/we are short WIN. 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.