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In this article we are going to discuss the dispute between Uniti Group (NASDAQ:UNIT) and its largest tenant Windstream. As soon as we understand that, a very lengthy exercise, we move on and discuss the value of Uniti, assuming it prevails. We will see that Uniti may become a very valuable company. However, if Uniti does not prevail it is doubtful that it can survive. The stockprice would then likely fall below $5 per share. So the lease dispute is very important.
The parties were one company until 2015 and then split in a sale and lease-back transaction of the cable assets. During the bankruptcy of Windstream over 2019-2020 there was already a dispute over the current lease payments. That ended in a settlement under which Uniti took over some more of the Windstream assets and agreed to invest in the network, the “GCI” programme (Growth Capital Improvements) for a total of $1.75 billion.
As per November 2021 a new dispute has arisen, this time over the future lease payments to be paid as per the renewal date of the lease contract in 2030. Windstream started the conflict with a very unusual statement on its website where it argued publicly the lease rent will come down from around $700 million in 2029 to under $200 million in 2030. In my December article I argued that Windstream couldn’t be right, however I now realize the matter is more complex.
You would expect that in such a dispute one party is right and one wrong. If we look superficially at the case that is indeed what we will find and it is not very difficult to prove that Windstream has the best argument and Uniti is dead wrong. We will start below by explaining both parties’ positions.
However, if we look more carefully we realize that Uniti is bringing up the wrong arguments. If Uniti were to defend itself properly it could claim that both parties made a mistake ab initio, from the beginning. Uniti can argue that back in 2015 they entered into a lease contract of which both parties didn’t know that it contained a material error. That error will also play up during the future determination process of the renewal rent as per 2030. It is about an annuity formula. Correcting for this error would turn the case completely upside down. Now Uniti has the best argument.
Lease renewal rent calculations (Windstream presentation November 2022)
The above mentioned Windstream presentation, slide 3, shows that if you take various reasonable assumptions regarding the input variables for the lease renewal rent calculation that the rent will come down substantially. The rent was set at $650 million in 2015 and would come down in the base case scenario to $197 million as per 2030.
To come to this calculation Windstream makes use of the annuity calculation as defined in the Master Lease Agreement. In my previous article I checked these formulas in MS Excel and indeed the calculations are all correct.
Back then I argued the input variables must be wrong, but after Windstream’s March 2022 disclosure I realised I was wrong. These input variables, interest rate, initial value of the lease assets and residual value do not change Windstream’s case. Windstream seems to have the best argument.
Uniti defended itself during the Q4 conference call in February ’22 and on 7 March, after Windstream’s March publication, at the Raymond James conference. Uniti’s most important argument is that Windstream should make use of ‘discounting’ of the residual value before entering that number into the formula. What Uniti is basically saying is that if the residual value of the lease assets is, say $5 billion in 2035, then that number should be made present first by dividing it by the lease rate over the five years between 2030 and 2035. In our example the value would become $5 billion divided by (1+ lease rate)^5. Let’s say the lease rate is 6% then the number comes down from $5 billion to $3.7 billion, a difference of $1.3 billion.
Now you see why the parties come up with such very different numbers around the lease rent in 2030. That decline of $1.3 billion in value over five years must be compensated by Windstream. Divide $1.3 billion by five and you have a difference in lease payments of $260 million per annum on this discounting argument alone.
The problem with Uniti’s argument is that, to us, it appears definitely false. In the above slide, below right you see that back in 2015 the residual value was set at $2.465 billion in 2030. From the documents made public during the 2019-’20 dispute we know where this number came from. It is the ‘uninflated residual value’ as calculated by Ernst & Young. It is impossible that E&Y discounted this number before publishing, and Windstream made that clear in the March presentation:
Windstream March 22 presentation (Windstream)
If you assume that the 2030 Uninflated Residual Value of $2.465B used to calculate the $650M rental payment was a discounted value consistent with Uniti’s stated methodology, then the implied non-discounted Uninflated Residual Value would have been $11.6B, representing an increase in value of more than 50% over the 15-year term for a predominantly copper asset in an analysis that assumed no inflation nor improvements
[Indeed, if Uniti were correct then E&Y would have estimated that the nominal value of the lease assets in 2030 will be worth $10.8 billion (2.465 * (1+10.35%)^15. I don’t know why Windstream has a different number.]
In other words, Uniti must be wrong and should have known that after Windstream’s March publication. However, Bill DiTullio, Uniti’s chief investment officer, continued to use Uniti’s debunked argument during the recent Raymond James conference. Uniti appears to on a road to self-destruction and better returns sooner than later.
Only after reading Windstream’s March publication I realized I was wrong and there was something more complex at hand. Neither Uniti nor Windstream had the right argument; we deem them both as mistaken in their use of the contract formula for annuity payments. I reached out to both parties but Windstream didn’t respond and Uniti repeated its position.
Let’s see what I tried to make clear to both parties.
To see that there must be something wrong with the lease contract let’s summarize the terms of that contract. The lease assets were valued at $7.45 billion by an independent appraiser. The lease interest rate was set at 10.35% and the annual lease payments were set at $650 million per annum.
Do you see the problem? First of all the lease interest rate of 10.35% was set higher than the then average funding cost of Windstream. How did that lead to lower funding costs?
Second, multiply 10.35% with $7.45bn and you get to $771 million of interest alone. That is more than the entire annual lease payment of $650 million. That is impossible. Assume you enter into a $200,000 mortgage at 6%, i.e. $12,000 of interest per annum, or $1,000 per month. For an interest only mortgage on these terms you would expect to pay already $1000 per month. It is impossible that you would pay less per month for an annuity mortgage since then you have to pay principal as well.
So we are certain that there is something wrong with the terms based on which both parties agreed the lease contract. It turns out to be an incorrect annuity formula, which the parties defined as:
Fair Market Rental = PMT(rate, nper, pv, [fv], [type])
rate = Fair Lease Rate
nper = Renewal Term
pv = Fair Market Value – Residual Value
fv = 0
type = 1 (lease payment due at beginning of period)
The error is that ‘pv’ and ‘fv’ should not be defined as above but should respectively be defined as just ‘Fair Market Value’ and ‘Residual Value’. Subtracting the two in the pv definition is wrong and leads to results that make no sense (which we already saw).
Let’s use the correct formula for the 2015 contract terms and see what happens. Since we already know the lease rate is wrong we fill in all the other terms and iterate at what rate the formula fits:
rate = ?
nper = 180 months (lease term)
pv = -$7.45 billion (initial value of the lease assets)
fv = $2.465 billion (residual value of the lease assets)
type = 1 (lease payment due at beginning of period)
$650 million = 12* PMT(6.01%, 180 months, -$7.45bn, $2.65bn, 1)
It turns out the real lease rate of the current contract is not 10.35% but 6%! Remember, this is a multi-billion dollar contract and one of the major terms, the interest rate, turns out to be over four percentage points lower than all stakeholders were told over the last seven years! Uniti as a public company should immediately tell its bondholders, shareholders and the SEC that the lease contract terms are not what they thought they were.
That is because this same formula must be used consistently with the approach taken in 2015. So this erroneous formula will also determine the lease payments as per 2030.
However, since both parties didn’t know the contract terms were wrong Uniti now can claim the contract is void. Uniti now has a far better defence against the calculations of Windstream and tell the judge that he should apply a corrected formula. Basically, and in my letters I instructed both parties to do so, Uniti and Windstream have to sit together as soon as possible to correct the mistake and publish the outcome.
There is no reason to go to court since both parties must acknowledge their contract is void. Neither Windstream nor Uniti can claim that the current contract terms were intentional. If they did than each management team can be accused of securities fraud. Note that both management teams ran public companies back in 2015.
Now let’s look at the claims of both parties and see what it means if we use the correct formula. What would that mean for the expected lease payments as per 2030?
In its November presentation Windstream provides a base case scenario under which the lease payments will come down to $197 million. All the other scenarios are small deviations from this base case.
Windstream uses the following numbers to calculate the lease rent for the five years as per 2030:
Renewal lease rate: 8%
Beginning Fair market value: $4.900 billion (2030)
Ending residual value: $4.083 billion (2035)
Using the formula correctly we get 12* PMT(8%/12; 60; -4.900; 4.083; 1) = $522 million. That is substantially more than the above $197 million.
In other words, if Uniti can successfully void the contracted annuity formula and replace it by the correct one we can expect that the lease payments will come down from about $700 million (ex. GCI interest) to $522 million as per 2030. That is a reduction of about $0.75 per share per annum.
Windstream Renewal rent (Uniti presentation)
In its Q4 presentation, page 12, Uniti alleges, based on Big Four appraisals, that the lease renewal rent should be in the range of $600-800 million per annum. Uniti provides three scenario’s which, corrected for the formula error, look like:
Input/ output
Windstream View adjusted
Big four (partial use GCI)*
Big four (full use GCI)*
Lease rate
8,00%
9,20%
9,20%
Term
60
60
60
Market value
-5700
-6700
-7200
Residual value**
4.702
5.745
6.056
Annual rent
615
762
837
*Windstream view adjusted means adjusted to Big Four appraisal methodology
** Re-inflated by the respective interest rates as Uniti wrongly discounted the BIG Four residual values
If we compare the annual rent numbers with the ones Uniti presented during the Q4 conference call we realize they are broadly similar (~ $600, ~ $750 and >800). This suggest that Uniti’s Big Four advisors made use of the corrected formula, not the contract formula.
Looking at the annual rent numbers we see that Windstream’s adjusted estimate goes further up to $615. If this were to be the rent in 2030 the Uniti shareholders would lose only $0.35 of income per share per annum. Uniti nevertheless thinks the final outcome will be closer to $750 million. That would be nice upside but since we cannot verify this, let’s not yet count on it.
Assume the above is not sorted out and Uniti loses the argument, what can we then expect from our investment in Uniti? Not much. In that case Uniti very likely will breach bond covenant triggers and enters into distressed debt territory. It is difficult to say whether Uniti can survive, maybe by cutting completely the dividend for many years, but it will almost certainly mean that Uniti’s shares will not be worth more than a few dollars.
But how does Uniti look like when the above is all sorted out and behind? Since it is now obvious that the parties cannot continue their crash course, we assume that they correct the annuity formula sooner than later*. The exact terms of the lease will only be known somewhere by the end of this decade but we assume for now that both parties have some fair arguments and therefore we use the above “Windstream view adjusted” $615 million annual lease rent as our base case.
In the period until 2030 we assume no changes will be made in the contract as a result of the upcoming negotiations. Uniti will receive from Windstream the base rent plus annual escalators, of 0.5% per annum, plus the interest over the GCI investments at 8%. The below chart shows how Uniti’s income from Windstream will look like over the period until 2035. As per 2030 we see the big reduction as a result of the end of the GCI programme and the base rent reset as discussed above.
UNiti Windstream Income (Authors calculations)
The chart starts at $722 million based on the Ebitda number as derived from Uniti’s Q4 presentation. Due to the annual escalators and the continuing GCI investments Uniti’s Windstream income increases to a little over $850 million in 2029 and then drops back to the renewal rent at $615 million.
Outside Windstream Uniti’s income will also grow rapidly over the coming years as Uniti is still investing about $150 million per year of success based capex in its network. Another source of new income is the so called lease-up where Uniti finds new clients renting its current network. The latter requires relatively low investments by Uniti and therefore generates high margins.
Being conservative we assume Uniti’s autonomous non-Windstream income growth will be 5% per annum plus 5% income over the success based capex. We assume $150 million per annum of success based capex. For the Non-Windstream income the chart until 2035 looks like:
Uniti non-Windstream income (Author’s own calculations)
Now we need to look at Uniti’s funding needs. From the above we learn that Uniti has about $890 million to spend on interest, capital expenditures and dividend.
We assume we keep the dividend for the entire period at 60 cents. The interest costs are set at the current $388 million and rise and fall with the principal balance of the debt outstanding. We assume average interest costs at 7%.
Uniti total income (Ebitda) (Author’s own calculations)
As we see, Uniti does not have substantial free cashflow in the next few years as it has to invest heavily under the GCI programme. However, we see that substantial free cashflow becomes available as per 2025. Assuming Uniti would not increase the dividend in the coming years we see that Uniti’s income will grow to over $500 million per annum or over $2.20 per share on top of the $0.60 dividend. What we learn is that Uniti in a couple of years will become a cashcow.
Every investor can do his own calculation how he values an income stream generating $0.60 of annual dividend per annum and generating total cashflow of over $2.50 dollar per share in ten years from now. I bet most investors come up with a number far above the current stock price.
Uniti and Windstream are currently in a fight that is not in the interest of both companies. Both parties made material mistakes in the arrangement of their lease agreement and they are equally to blame. Uniti should admit that its current defence is wrong and is not in the interest of its stakeholders. As soon as Uniti changes course Windstream will soon realize that the current fight is not fruitful and should be settled by changing the annuity formula in the lease agreement.
Uniti is currently under serious threat and should change course quickly. As soon as the new arrangement with Windstream becomes public, Uniti is in a very healthy shape. Over the next few years Uniti still has some heavy investments to do but in a couple of years should become a highly profitable company. Ten years from now I expect Uniti to generate free cashflow of over $2.50 per share.
* Note that I filed a complaint with the SEC regarding the wrong disclosures by Uniti regarding the terms of the lease contract.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
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