Last we touched on Uniti group (UNIT), we argued that the dividend would likely be cut and that cut would help the bondholders. We thought even in a worst-case bankruptcy renegotiation from Windstream (WIN), UNIT could comfortably cover the interest payments.
Assuming a bombed out 30% reduction in Windstream Lease payments in a renegotiation, UNIT's EBITDA would drop by about 20% (WIN is about 66% of UNIT's revenues), resulting in EBITDA interest coverage moving to about 2X. So a worst case of 2X interest coverage alongside the potential to make 12.5% compounded is the best offer the market is likely to present and investors should grab it both hands.
However, can the dividend be reduced or eliminated without tripping up REIT rules for UNIT?
The IRS implements the REIT rules and oversees what qualifies as a REIT. The Internal Revenue Code requires a REIT to adhere to the following essential rules that at least 75 percent of the corporation's income must be earned from real estate as rent, real estate interest or from the sales of real estate assets, at least 75 percent of the corporation's assets must be real estate assets; and at least 95 percent of income must be passive.
The more important rule in question is that REITs are required to distribute at least 90 percent of taxable income annually to shareholders as taxable dividends. In other words, a REIT cannot retain its earnings.
With UNIT distributing $2.40/share annually, investors assume that this is substantially similar to its taxable income and eliminating will be a problem without triggering REIT rules. We look at this below in more detail.
Dividends# income before income taxes # taxable income
While investors may confuse these three terms often, they are very distinct. For the first three quarters of the year, UNIT paid $1.80 in dividends in 2018, which works out to about $315 million on 175 million shares. We use the first three quarters as we don't have UNIT's annual report to make comparisons. In sharp contrast to the dividends paid, UNIT reported a loss in the first three quarters of the year.
Source: UNIT 10-Q
UNIT was able to pay out such large dividends, in spite of a net loss is because of the non-cash impact of depreciation. So if UNIT's taxable income was the same as the income before income taxes shown on the income statement above, UNIT would have no obligation to pay any dividends whatsoever.
Why taxable income can be different from income before income taxes
There are many reasons the two can be different and this is not meant to be an accounting course. We will however focus on the two main reasons the two can defer. The first is that certain losses cannot be deducted from overall income for calculating the taxable income. The biggest example of this is a goodwill impairment, the kind which Kraft Heinz (KHC) took last quarter. The accountants estimated that they had overpaid for the acquisition (we are still working on our surprised face), and there was a gigantic impairment and a loss on the income statement. This kind of write down does not reduce the taxable income and the loss in value can only be claimed when the business is sold or completely abandoned.
The second reason is that depreciation shown on the income statement is often different than the depreciation allowed by the IRS. All public companies are mandated by the Securities and Exchange Commission (SEC) to use GAAP, even though GAAP is not written into US law. Straight-line depreciation, under GAAP, is a standard accounting procedure when calculating corporate financial statements for auditing purposes. A residual or salvage value is often assumed with GAAP. However, for income tax purposes, the IRS requires companies to follow the Modified Accelerated Cost Recovery System (MACRS) when calculating asset depreciation. This results in a fully depreciated asset resulting in a book value of zero.
The key impact here can arise in an older REIT where the financial statements show a certain amount of depreciation, however for tax purposes a much larger set of assets are fully written down to zero. In other words the financial statements still show a loss, but the IRS will find a profit. Considering the relative new existence of UNIT, we think this is an impossibility. A subset of the above condition is if IRS requires depreciation rates that are slower than the company uses for GAAP. In other words taxable income for IRS is higher than the income for tax purposes as IRS mandates less depreciation deducted for tax. This again is extremely rare, as almost always, the opposite is more likely to be true.
Putting this information together, it appears that even today, even assuming WIN's lease is held as is, UNIT could eliminate the dividend.
What if we are wrong
Our belief based on the financial statements we see is that UNIT would not have to pay any dividends currently. However, even if they do, the amount is substantially lower than the current dividend. Even this amount does not need to be paid via cash.
Source: UNIT 10-Q
If UNIT decides it is battening down the hatches because a category five hurricane is coming, it can pay its dividends in more UNIT equity. Literally not a single cent has to leave the company coffers.
Even if UNIT did not want to go the equity route, it has substantial time to defer dividends. It can pay its next dividend directly in 2020 under Section 858. Section 858 of the IRS Code allows the REIT to elect a specified dollar amount of a dividend declared in the following year to be treated as having been paid in the current year. This is permitted provided that the dividend is paid before the due date of the REIT’s tax return and prior to its first regular dividend made after such declaration for that subsequent year.
Based on the evidence presented above and the fact that in almost all outcomes, UNIT is better off preserving more liquidity than less, UNIT has a higher probability of cutting the dividend. This is true even if WIN leases is held as is. Our options calculations last showed that an annual 40 cent dividend (10 cents a quarter) is the most likely as the payout, but we will know soon for sure. We will also retest that theory that dividend cuts can never really be "priced in".
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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: Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints. Tipranks:No Rating