Uniti's (NYSE: UNIT) share price has fallen by over 50% in the last days of an adverse legal ruling that might trigger or accelerate a default of its largest customer, Windstream (NYSE: WIN). There are speculations about the fairness of the judicial decision, the safety of the master lease agreement between Uniti and Windstream and the risk or the quantum of a dividend cut at UNIT.
In addition to the legal uncertainty, a key issue is the falling Revenue base of the sector whether it is at CenturyLink (NYSE: CTL), Frontier (NYSE: FTR) or Windstream. In a falling revenue (i.e., deflationary) environment, debt can no longer be rolled over but needs to be repaid as the borrowing base is declining.
We need to understand the rationale of Windstream and Uniti's stakeholders to assess the real value of Uniti's shares. I think the downside risk is substantial and that a suspension of the dividend is more likely than a reduction.
Uniti and Windstream
In this article, I assume the reader is familiar with the Uniti-Windstream arrangements. Windstream has sold fiber assets to Uniti and is paying to Uniti to use it under a Master Lease Agreement ("MLA"). I believe this is an over-engineered piece of finance, but this is not the topic of this article (cf. past article).
A consequence of this arrangement is to have created a super senior instrument in the Windstream capital structure to the benefit of UNIT's stakeholders. The super seniority comes from the fact that the MLA may not be renegotiated in a Chapter 11 process of Windstream. The valuations of the bonds and equity of Uniti and Windstream suggest that the market believes in this super-seniority: Uniti's market enterprise value represents 69% of the combined Uniti-Windstream EV but only 20% of the potential loss (cf table # 1)
The MLA represents 80% of UNIT's EBITDA and, in this article, we will often recombine Uniti and Windstream to understand the position of Uniti Group better.
Table # 1: Frontier, Windstream, and Uniti
Windstream has just announced its Chapter 11 filing. This is unsurprising as both secured and senior debt trading at a deep discount. We forecast Windstream's cash flows in table # 2 2; Our key assumption is that revenues will keep decreasing before stabilizing. The combination of falling revenue and growing cost (capex being capex and the MLA), Free Cash Flow ("FCF") will not remain positive for very long. On the current trend, Windstream will not be able to serve interest payments within the next 12 to 24 months; this is what it means to have a highly speculative rating of Caa3 (shortly to be in the D range).
Table 2: Windstream: revenue forecast
The legal case with Aurelius just gave the opportunity to the secured creditors to take control now rather than wait until next year. Based on our forecast above, we estimate the NPV of the positive Free Cash Flow to only around $ 1.4bn (discounted at 7%). This does not cover the secured debt, as such, secured lenders should be in the driving seat.
Assessment where the EBITDA is being spent (table # 3); This is not just about an MLA reduction:
- Immediately stopping senior interest payment will save $ 260mn per annum (equivalent to 40% Uniti rent cut).
- When the potential recovery is only $ 1.4bn, $ 260mn or senior interest or $ 300m to Aurelius matters
- Secondly, some OIDB are not related to the assets "pledged to Uniti," these should be sold or spun-off. If this is 25% of Windstream OIDBAR, this could be worth $ 1.8bn for the recovery to $ 2.15bn.
- In the approaches above, Windstream's bondholders are merely executing a run-off as long as there is some positive cash flow. They would then put the company into Chapter 11 again or give the keys back to Uniti in a Chapter 7 filing.
Another option is to negotiate with pure reduction with UNIT. In my forecast, a 25% reduction is needed to stabilize Windstream for a decade or more, and this would bring the NPV7% to $ 3bn. However, the benefit of a reduction in accrues slowly to creditors, and it might be difficult to get both a clean reduction and a spin-off. When I run into NPV15%, the approach of selling all non-UNIT assets, running the business for cash and minimizing Capex, would yield similar results for the secured bondholders and faster.
This is where the power balance between Uniti and Windstream may not be so much in Uniti's favors. There are ways for Windstream's secured loans to get their capital by running the business for cash without a reduction, which would leave Uniti in an uncomfortable and uncertain situation (eventual bankruptcy, underinvestment, etc).
Table # 3: options open to Windstream's secured lenders
UNIT: rationale of the bondholders
Now put yourself in the position of UNIT's bondholders; You might already have lost money in Windstream or FTR's bonds, and you see the industry revenue declining. You need to understand that this revenue deflation is essential in the creditor's assessment: it suggests that fiber assets are not perpetual assets as contemplated at the time of the spin-off. If the fiber assets are not "perpetual," the debt needs to be repaid. Thus, the criteria, for dividend or debt sustainability analysis, is not simply Uniti have enough cash flow to cover interest but does not have enough cash to repay the debt and the interest.
Back to being a bondholder. What would you do if you had the opportunity to act? Do you let Uniti's management continue to pay a dividend or make acquisitions? Do you plan to roll the debt when it matures or believe other bondholders will roll-over your debt? Do you think any of these approaches will help your career when things get messy?
Probably not more likely you would run a few scenarios and realize that the combination of Windstream's actions (described above), potential continued negative revenue growth and the legal risk might put your capital at risk or make it very difficult for Uniti to repay the loan in any reasonable time frame.
Windstream's Chapter 11 should give back control to Uniti's bondholders as it could trigger a cross-default in the MLA and then Uniti bonds. It is in the Uniti's bondholder's interest to be conservative and suspend the dividend to start reducing the debt.
Bondholders are not paid more to take the view that the industry will recover thanks to 5G or whatever; they are not paid more to take a view on binary catastrophic legal risk. If these issues are resolved, the equity will be able to refinance or assume the bondholders to allow dividends again. The bondholders do not have that clarity now.
A few scenarios
We assess the NPV or Uniti's Free Cash Flow during the same scenarios when we contemplated with Windstream (table 4), using a similar cash flow forecast. What do we see?
- Even if 100% of the cash flows are diverted, the debt can only be repaid by 2030 or later.
- If Uniti keeps paying 50% of the dividend ($ 200m), that will delay the debt repayment by 5 or 6 years to 2035 or 2036.
- Worse, in some adverse scenario of continued revenue deflation and legal losses, the senior bondholders could lose money and never be repaid if 50% of the dividend is maintained. 19659017] A rent reduction of 25% might stabilize Windstream and Uniti, but even with all cash flow diverted to debt repayment, it would take 12 years to repay the debt, and that still leaves Uniti bondholders exposed to further degradation of Windstream's business and legal risk
The point is not to guess which scenario is more likely but to recognize that there is material uncertainty. Bondholders should seek to pay dividends at least until clarity is resumed and are unlikely to wait for a reduction to act.
Uniti share price may fall dramatically if the dividend is suspended. In our modeled forecast, we see the fair value falling between $ 0.5 to 6 per share (table 4). The fall is partly due to the time value effect of delaying dividends until the debt is repaid, which is very conservative.
Table 4: Uniti Stakeholder – positions in various scenarios
A few words on the methodology
We use a similar forecast approach on Uniti as we did for Windstream. If of interest, you can send me a private message to receive the tables. This type of analysis is time consuming but quite necessary to be able to take any child in a distressed fixed-income situation.
Secured bonds of Uniti
Using this type of analysis, the secured bonds of Uniti are It is quite difficult to break into a perfect storm or negative long-term growth, legal challenge and continued payment of $ 200m or dividends.
A price in the mid-high 80% seems difficult to break if bondholders of Uniti can take control quickly. Personally, being particularly conservative, I would wait for an even lower entry point. This type of entry point can be created by combining the long Uniti's secured bonds with a smaller short on Uniti shares.
We have not tried to analyze the intrinsic value of Uniti; There are too many uncertainties to do so confidently. We have limited ourselves to understand the potential actions of the bondholders of Windstream and Uniti to assess the risk of a dividend suspension
Windstream's Chapter 11 is likely to put Uniti's bondholders in control of Uniti. Whether or not the MLA is renegotiated, we believe it will be a bondholders' interest to suspend dividends at Uniti and start repaying the debt balance.
We think the downside risk in Uniti's share price is large and the share price could be below. $ 5 in this uncertain environment
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.