NicoElNino
NicoElNino
I was intrigued to see Uniti Group (NASDAQ:UNIT), a REIT yielding around 9%. As always, one has to wonder if there's something going wrong or if the market is mistaken. Despite the high yield, the market rallied on the shares after Q4 earnings came out. Is it a sign of improving prospects?
After looking at this business, however, it seemed to me that there were many challenges, some of which stretch back to its origins. While there may be potential, I ultimately decided it's much safer to treat this as a SELL and look elsewhere. Let's go over why.
As a REIT, Uniti primarily earns income from its leased properties. In their case, these are mostly properties that play a role in the communications industry. They report these operations in two segments: Leasing and Fiber.
2023 Form 10K
The table above shows that the bulk of the company's revenues (~74%) comes from their Leasing segment. Additionally, Leasing revenue primarily comes from rental income, while Fiber earns incomes for various services. Let's look a bit more at what these segments do then.
This segment earns rent from the following types of properties:
Typically, these assets are acquired through a sale-leaseback. Uniti aims to acquire properties from businesses in the communications industry where the negotiated lease provides them a satisfactory yield. The benefit to the customer is that it frees up their own capital, allowing them to pay down debt or grow their business.
In their recent Form 10K (pg. 8), Uniti disclosed that most of this segment's revenue comes from its contract with Windstream:
For the years ended December 31, 2023, 2022, and 2021, 67.3%, 66.5% and 66.4% of our revenues, respectively, were derived from leasing our Distribution Systems to Windstream.
Annual rent from the Windstream lease is currently $672M, with an annual escalation rate of 0.5%. The lease expires in 2030.
In total, Uniti has over 330,000 miles of fiber and copper assets that it leases across 21 states.
2023 Form 10K
This segment's revenues are diversified and broken down as such:
2023 Form 10K
In essence, Fiber provides important services to customers within their grid, providing an additional source of revenue that, unlike the Leasing segment, is distinct from their REIT operations. Tables below show that Fiber possesses 37,500 miles of fiber routes and 25 towers across 13 states.
2023 Form 10K
These various services go out to individual businesses and locations, like schools and libraries, and involve activities like installing fiber or even construction of infrastructure assets.
Looking at this company's balance sheet, one might notice the amount of liabilities Uniti has.
2023 Form 10K
Liabilities exceed the assets, meaning there's no protection for shareholders in the event of liquidation. Moreover, even the debt alone exceeds the reported value of the assets. Now, companies have had negative book value before and turned out just fine, but let's look more closely at the nature of their debt.
About $4.4 billion of this is through senior notes with maturities between 2028 and 2030, and interest rates ranging 4.75% - 10.5%. (Of this, about $2.6 billion of that principal pays the 10.5% rate and is due 2028.) About $430M comes from convertible and exchangeable notes. $208M is from their credit facility. The table below shows the breakdown.
2023 Form 10K
Additionally, the company has what it calls an "UPREIT structure" through a subsidiary Operating Partnership. Most of Uniti's assets and other subsidiaries are owned through this business. Uniti may also choose to raise capital by selling limited partnership interests in this business, as opposed to selling shares of UNIT. This has not occurred since 2017, however (pg. 44).
Uniti Group was initially formed in a spinoff from Windstream in 2015. With the assets it received, the company chose to classify itself as a REIT. Thereafter, Windstream became Uniti's biggest customer under its Leasing segment. For the most part, the company's revenues have not grown substantially, stabilizing roughly around 2018.
Author's display of 10K data
While there hasn't been much growth, there has been turbulence. When evaluating a REIT, which distributes most of its earnings as a dividend, a good measure of distributable earnings isn't Net Income but Funds From Operations. Looking at that history, we see the following:
Author's display of 10K data
We see that FFO has been less since revenue growth slowed and that dividend payouts had to be reduced substantially. I'll throw in this chart just so that folks can see the material impact to dividends per share.
Seeking Alpha
The annual rate declined from $2.40 in 2018 to the current level of $0.60. Some might notice that even before the cut that payouts were sometimes in excess of cash flow. What happened in 2019?
As you can probably guess, Uniti's spinoff from Windstream had to with Windstream's own financial problems. In its 2018 Form 10K (pg. 32), Uniti disclosed a Going Concern, which noted:
There are conditions and events which raise substantial doubt about our ability to continue as a going concern and in its opinion on our December 31, 2018 financial statements, PricewaterhouseCoopers LLP, our independent registered public accounting firm, expressed substantial doubt as to whether we could continue as a going concern within one year after the date the financial statements are issued as a result of Windstream’s bankruptcy petition and its potential uncertain effects on the Master Lease.
Shortly thereafter, as disclosed in its 2019 Form 10K (pg. 36):
As further described below, on July 25, 2019, in connection with Windstream’s bankruptcy, Windstream Holdings and Windstream Services filed a complaint...against Uniti and certain of its affiliates, alleging, among other things, that the Master Lease should be recharacterized as a financing arrangement, that certain rent payments and tenant capital improvements made by Windstream under the Master Lease constitute constructive fraudulent transfers, that the Master Lease is a lease of personal property and that Uniti breached certain of its obligations under the Master Lease.
Consequently, with the disruption Windstream's bankruptcy created, this forced them to reduce the dividend. After Windstream's bankruptcy was finished, the current lease that I mentioned earlier was negotiated and has been in effect since then.
Still, the company is working hard to be cash-flow positive, amid its interest expenses and heavy capex. In 2023 (pg. 46), they disclosed:
Our 2023 capital expenditures of $417.0 million and dividend payments of $107.4 million exceeded our 2023 cash flow from operating activities of $353.1 million, which led us to seek additional external sources of capital.
These sources of capital included some of the notes I mentioned before but also an asset-backed loan facility that was established in February of this year and provides up to $350M in capital.
With all that said, there's a lot to consider here about the ability of the company to pay and grow its dividend over time, while remaining solvent, so let's look at what will influence that.
Management is most optimistic about its Fiber segment. In its Q4 2023 earnings call and presentation, management talked about the growth potential of this segment and its ability to earn higher returns than the Leasing segment.
Q4 2024 Company Presentation
They've also identified a large market into which they can expand and provide these services to markets in their sphere.
Q4 2023 Company Presentation
Yet, there is a limit here. In the earnings call, management noted:
Although enterprise sales represent about 5% of our total revenue today and will likely always represent a minority percentage, it remains a critical element of our profitable lease-up strategy.
Thus, I believe that the key to success will be making the Leasing segment operate successfully, such that Uniti can repay the substantial debt that it has accumulated.
Since its bankruptcy proceedings, Windstream has operated as a private company. This makes it harder for investors such as ourselves to evaluate its financial condition, which will significantly impact that of Uniti. I'll also note that even when it was public, Windstream has caught Uniti off guard before. In their 2018 10K (pg. 32), management wrote:
We expect Windstream will continue to perform on the MasterLease and believe it is unlikely that Windstream will reject the Master Lease because the Master Lease is central to Windstream’s operations.
Nevertheless, Uniti was hit by the suit I mentioned earlier. What was the settlement they had to reach? I'll share passage from the 10K itself:
Terms of Settlement (2023 Form 10K)
Obviously, those obligations affected the dividend and will continue to do so for some time. I think it's unclear if Windstream will continue to be a good partner for Uniti.
At the same time, there have been recent talks between the two of possibly re-merging. I don't know if that would materialize, but it's worth considering for folks who came here for the dividend yield. What exactly shareholders would get (or lose) from it would depend on the nature of such an agreement.
Since there is much eagerness on the part of management to grow the fiber business (which is not part of their REIT operations), sufficient success there could lead to the company no longer qualifying for REIT status, which could impact its dividend policy. I think anyone who decides to own the shares should keep that in mind.
One of the issues with this debt isn't just that there is a lot of it. As I mentioned earlier, about half of it costs an expensive 10.5%. With so much principal due within the decade and room for setbacks, there's a danger that the dividend may need to be cut or suspended to comply with covenants. There's also danger that they may not be able to refinance some of this favorably, considering the high yield much of their balance sheet is already shouldering. I'll quote CEO Kenny Gunderman about the kind of pricing they get on their leases, when asked about it during the earnings call's Q&A:
But with the hyperscalers as anchored customers, you're not pricing to perfection in that 5% to 10% lease -- anchor yield, you're really -- it's much more collaborative in terms of sharing the cost of initial builds.
I would agree that they are not pricing to perfection, with lease yields seeming to break even with the rate of the interest expense. I am not sure how the company is supposed to get onto a track of positive cash flows with this. Moreover, if they felt confident about that, why would they even need to consider going back to Windstream? If they are forced to refinance debt at even higher rates as maturities come due, this becomes even less attractive. I see this as a reason to take pause.
With the numerous uncertainties regarding profitability and solvency, I cannot perform a valuation on this company. A 9% yield is enticing, but it's a $1.5B market cap for over $5B in debt with no liquidation safety. The math isn't kind to owners of the common here.
I do think there are other interesting things about it from an operational perspective, but what matters to the long-term investor is the financial aspect. Healthy cash flow is especially important for income investors who might be drawn to this high yield.
Until the company has made more progress on improving its balance sheet and generating cash flows to sustain its interest expense, capex, and dividend, I think investors should play it safe and treat this as a SELL.