Description

Thesis:

We were planning on pitching Uniti unsecured bonds this weekend, on the thesis that this year, there is a hidden, underappreciated catalyst that significantly increases the probability that Uniti and Windstream will strike a deal and the capital structures will re-rate. A late Friday night headline hit that, indeed, Uniti and Windstream are in talks to merge. While this new information might tip market participants toward our conclusion/views, there is obviously still risk in a deal going through (in the prior iteration of a rumored deal, Zayo/Windstream/Uniti could not agree on terms). But we think the probability this time around is significantly higher, and therefore we recommend a long of the Uniti unsecured bonds (and feel comfortable pressing the trade even in the event bonds tighten further on this merger headline).

The crux of our thesis is that Windstream is highly incentivized to solve its lease issue ahead of the massive $42 billion federal broadband subsidy program (BEAD – Broadband Equity Access and Deployment) that is set to ramp this year / early 2025. The reason being is that a significant portion (around 20-40%) of Windstream’s ILEC footprint is likely eligible to receive subsidies for broadband deployment, and we believe that a large portion of Windstream’s current broadband customer base is in these areas (which are more rural and have less or even no other competition). Therefore, at worst, BEAD funding represents a required defensive measure for Windstream to maintain a large amount of its current broadband customer base; at best, in the case that Windstream’s current penetration in these areas is lower than we suspect, the BEAD program can still be a very attractive offensive measure for Windstream to extend its fiber build plans. What remains clear is that Windstream both could not and would not want to deploy more capital in conjunction with broadband subsidies if there is not clarity or a solve around the Uniti lease, as (1) leverage is high and cash flow / liquidity is tight at Windstream with their current fiber build plans and (2) ~80% of Windstream’s ILEC footprint is owned by Uniti and any further fiber builds in these areas would accrue to the value of the lease. Elliott, PIMCO, Oaktree and the other distressed owners of Windstream have no incentive to put Windstream capital into builds that benefit Uniti’s position, potentially ahead of a second required restructuring if they can’t reduce the Uniti lease enough at renewal in several years.

While the ultimate form of a deal or solve for the lease is unclear, we think a simple recombination of Uniti and Windstream makes the most sense and is the most achievable. Even though leverage would still be high for the recombined business (high 4x range), peer ILECs undergoing fiber builds such as Frontier, Consolidated and Ziply have similar or even higher leverage levels with junior or stretched 1L bonds trading around or inside of 10%. Uniti’s uns in the 15-16% range have an attractive path to tighten towards these levels, providing a near term, catalyst driven opportunity to earn ~30% returns. Finally, we really like this trade set up because of the downside protection, as (1a) this is a 1-year window trade, so the only existential risk you are taking is that Windstream does something proactively to blow up the lease, which represents a Mutually Assured Destruction risk to us and has a remote probability; (1b) Uniti’s business has minimal volatility, with the fiber business being a steady performer and obviously the Windstream lease being fixed/contractual, therefore any idiosyncratic business risk is low in our view; and (2) beyond a 1 year hold, even in the event that Windstream gets the full lease reduction it desires, we think there is pretty clearly value through the Uniti unsecureds in a restructuring, so your current entry around the high 60c range with multiple years of coupons buying down your basis <50c provides ample downside protection of any permanent capital loss.

Background / context & why we think now is the right time for a solve:

There have been several previous VIC write-ups on Uniti where readers can get a bit more detail on the business, but here we will keep the background brief and focus more on the context and clues that we have seen indicating a recombination / solve is highly likely. For a (very) quick background: Uniti was spun out of Windstream back in 2015 as a REIT comprising the physical copper and fiber plant (longhaul and middle mile fiber that is, as most if not all of the homes passed back then were still copper DSL) of Windstream’s network in ~80% of its footprint (a handful of state PUCs were problematic and therefore Windstream ended up keeping its ILEC assets in these states). Windstream itself is a combination of an ILEC/RLEC similar to Frontier and Consolidated, as well as a CLEC through its historical acquisition of PAETEC and other regional CLECs, competitive regional fiber players, etc. Uniti acquired several regional fiber players as well to further diversify away from Windstream. Will go into more detail on the numbers later on in the write-up, but for now its just important to note that the majority (~2/3) of Windstream’s profitability is derived through its ILEC assets (called Kinetic) and the majority of Uniti’s profitability (~80%) is through the Windstream lease.

In 2019, Windstream filed for bankruptcy after an explosive ruling that the company defaulted on its debt from the original Uniti spin-off transaction. It makes for a fascinating case, but for the purposes of this write-up, we would highlight just a couple key points that we see as relevant for context and for the pitch:

1. While Uniti and Windstream ultimately ended up settling and there was never a formal ruling on the validity or valuation of the lease, we would point out that Windstream’s capital structure gradually collapsed through the process, ultimately leaving the fulcrum at the 1L. The uns were never really in it post filing save for hold-up value / outside shot that the lease would be recharacterized, but the 2L was originally eyed as the fulcrum, only to have some of those players (like Elliott) shift their holdings weight towards the 1L and zero out the 2L. We think these actions indicate that distressed participants in Windstream did not feel great about their negotiating leverage.
2. The re-cut lease agreement had two main provisions – (a) while there would be no headline cut to the lease rate, Uniti would fund fiber overbuilds of the copper network, committing $1.75b total investments through 2030 at a cost of 8% + 0.5% annual escalator, and (b) the lease would be bifurcated between the ILEC and the CLEC, which would facilitate any future split up of Windstream’s assets.

Windstream emerged in the fall of 2020, and from there, the fact pattern that follows clearly indicates that both of these companies need a deal that solves the lease:

• Uniti continued to try to find a deal that would further diversify it from Windstream, but was only able to do small, marginal transactions. Uniti’s CEO has also continually said that they have strong interest from PE/infrastructure capital in a strategic transaction, but nothing has ever come of it (not even a rumored deal, to our knowledge)
• Windstream has worked on fully separating its CLEC (both the asset light, managed service mid-market enterprise business as well as the wholesale fiber business) from the ILEC in order to split, but has been unsuccessful so far; we believe no one wants the enterprise asset, and the wholesale fiber asset, for which Goldman was rumored to be running a process as of early last year, has still not transacted (which we believe is part likely due to price, part likely due to the fact that the main buyer universe is not positioned to transact i.e. Lumen and Zayo).
• Uniti has consistently traded at a discount to what it thought was a fair cap rate on the Windstream leasing side; clearly the market is pricing in some probability of a lease cut on renewal.
• There was a rumored deal on the table at $15 for Uniti, with Zayo acquiring both Uniti’s wholesale fiber business and Windstream’s CLEC enterprise + wholesale fiber, and then EQT investing in the Windstream ILEC recombining with Uniti leasing (EQT is a co-owner of Zayo, along with Digital Bridge). Uniti’s stock traded up toward the $14 range at its peak. But the parties were never able to fully agree on terms.
• Windstream/Elliott subsequently proceeded to publicize their read of the amended lease, arguing that they see the lease potentially dropping to as low as $200m; this was a very clear ploy to pressure Uniti to a deal through the public markets.
• When speaking to both Uniti and Windstream, they both cited the other’s capital structure / liquidity issues, clearly hinting what they thought they saw as negotiating leverage to push the other party closer to their terms; but both sides have since solved any near-term issues with additional capital raises or refinancings.
• Windstream has moved on from its long time CFO and CEO. Notably, its old CFO Bob Gunderman is the brother of current Uniti CEO Kenny Gunderman. The new CEO of Windstream is a telco veteran who was previously chairman. We think this is a potential tell that Windstream is shifting to deal mode, away from the prior management that was responsible for building the business and prepping it for a split, recombination with Uniti, etc.
• We previously have heard rumors that Elliott had been buying Uniti unsecured bonds. Alone, this fact is obviously not that meaningful, both as a rumor and if true, as it could be logical even absent some sort of well-informed view on Windstream facilitating a solve of the lease. However, in conjunction with the other fact pattern here, we think it is noteworthy.
• Uniti’s stock has traded down towards all-time lows. Its cost of capital is laughably higher than the rate at which it is investing in / subsidizing Windstream’s fiber network overbuild (the 8% rent + 0.5% escalator).
• Both sides have communicated that they still see value in a deal.
• Friday night headline that Windstream and Uniti were in discussions to merge.

We think the evidence here overwhelmingly indicates that both sides need a deal. Let’s quickly spend some time on why now is the exact right time for a transaction.

BEAD is a massive $42b federal subsidy program to connect the most rural / least dense homes in America to reliable broadband (~10m homes estimated as the ‘target’ currently). Homes without current broadband or broadband < 25 meg download / <3 upload will be targeted first (unserved homes), followed by homes below 50/5 (underserved). It will be administered at the state level, with each state running their own auction program with the $$$ allocated to it based on number of eligible homes. While we won’t bore you with all the technical details here, would simply point out that the process has begun ($$$ allocation to states set, with the states now forming their broadband offices and working on auction plans that will need to be approved by the NTIA) and the auction processes are estimated to begin in states later this year, with funds flowing in late 2024 / early 2025.

Windstream is very well set up to take advantage of this subsidy money:

• It is the most rural of the larger ILECs/RLECs.
• It was one of the larger participants in the Rural Digital Opportunity Fund (the prior federal broadband subsidy program administered by the FCC).
• Its current fiber build plans will only cover ~2m of its 4.5m total homes passed. Per Windstream’s disclosure, roughly 20% of its homes passed have speeds <25 meg, and 25% are between 25 meg and 100 meg. The exact eligibility of homes in Windstream’s footprint will also be determined by its competitor’s speed profile (i.e. if cable has a >100 meg option where Windstream only has <25 meg, the home will not be eligible), but there is a strong correlation to Windstream’s broadband speeds and its competitive set. Historically, Windstream has disclosed that a significant portion of its homes passed have no cable competitor (15-20%), which lines up well with the portion of Windstream homes that have <25 meg today.
• Windstream has done some fiber build extensions adjacent to its own footprint (to overbuild AT&T for example); that could be a further opportunity for it to win subsidy $$$ in the BEAD auctions.
• Windstream currently has ~780k copper DSL customers and ~360k fiber customers, against ~1.6m fiber homes passed of the ~4.5m total homes. While we don’t know what speed profile these ~780k copper DSL homes have or even how many have actually been overbuilt by Windstream’s own fiber but just haven’t yet switched, we suspect that these customer over index to where Windstream has lower speeds and lower competition as (1) the mid 20% implied penetration against just the copper homes passed skews much higher than its ILEC peers, who are closer to low-to-mid teens penetration, and (2) Windstream has one of the highest broadband ARPU’s of the ILECs. Therefore, we believe that many of these customers / homes passed will be eligible for BEAD $$$, and thus represents a required defensive measure for Windstream to pursue, else some other participant like Charter or a local broadband company wins the funding and overbuilds Windstream.
• Finally, BEAD looks like it will favor fiber overbuilds versus fixed wireless or satellite, as well as scaled players with resources and operational history, after the RDOF debacle (allocated substantial amount of funding to smaller, less resourced fixed wireless players like LTD Broadband that subsequently defaulted on its funding obligations).

We are still in the land grab phase of fiber overbuilds in the US, and the BEAD program represents a sizeable opportunity / defensive measure that Windstream needs to pursue. Windstream needs to solve the lease issue with Uniti before committing to this program, however, as (1) it needs the additional financial flexibility to invest alongside these stimulus $$$, and (2) it needs to be certain that the capital it invests and value it creates will accrue to its equity owners, and not just Uniti.

Pro forma analysis, comps and valuation:

Windstream is about a $1.5b EBITDAR business. ~$1.1b of this EBITDA is from its Kinetic asset (i.e. the ILEC), $250-275m from the low margin CLEC enterprise business, and ~$200m from the wholesale fiber business (with the delta being shared corporate overhead and a small UCaaS piece of the business). We think EBITDAR going forward can hang around these levels, with perhaps a slight decline, assuming the current fiber build plan. Kinetic will be stable to slightly growing with the ongoing ramp of fiber penetrations, but slightly offset by the higher copper DSL penetration, which will erode over time. Wholesale may be able to sustain MSD topline growth with good incremental margins, depending on how much mgmt. continues to invest in the business; for context, this business will do ~$200m EBITDAR this year vs ~$150m last year. Enterprise is the real weakness, but we think a reasonable mid term floor of around $100m exists, which is 20% margins on a ~$500m run-rate “strategic” revenue base; this is basically next-gen / modern enterprise managed service and access, while the rest of the ~$1b enterprise revenue is legacy products like MPLS, TDM, etc and is going away fairly quickly.

On the Uniti side, the current run-rate on Windstream’s cash lease payment is ~$700m. Other leasing provides another ~$80m revenue/EBITDA. And then the Uniti fiber business is a ~$300m topline business doing ~$120m of EBITDA. Uniti fiber has been a steady grower over time, which makes sense given the company has always invested a lot of capex in this business.

Windstream has about $2.4b of debt (all secured / super priority) while Uniti is about $5.7b, of which ~$3.5b is secured and ~$2.2b is unsecured / converts. The structuring of a merger between Uniti and Windstream is TBD, but simply smashing the businesses and cap structures together can give us a rough sense of leverage levels and LTVs. Combined the business will be about $1.7b of EBITDA ($1.5b Windstream EBITDAR + $120m Uniti fiber + $80m Uniti non-Windstream leasing), have ~$5.9b of secured debt and $8.1b total debt – levered ~3.5x thru the secured and ~4.75x total.

Frontier is levered low 5x gross, with ~4x of secured debt; it’s 2L bonds due 2029/30 trade inside 10%. Consolidated Communications is closer to 7x gross leverage in a stretched unitranche; it’s 1L bonds due 2028 trade around 10%. Ziply is in the mid to high 5x gross leverage, with mid 3x thru the secured; its uns due 2028 trade inside 9%.

On valuation, we approach it via a SOTP, given the 4 main segments pro forma: (1) Kinetic, (2) the combined wholesale fiber businesses, (3) non-Windstream leasing, and (4) the enterprise CLEC.

1. For Kinetic, we would value the ~$1.1b at 7-8x EBITDA, so call it ~$8b of value. For context on comps: Frontier currently trades around 8x EBITDA (we think it is undervalued here though), Consolidated’s takeout multiple by Searchlight is around 9x, and Ziply we heard got its recent equity funded at a low teens EBITDA multiple. The key difference with these companies in our view, however, is that all 3 are substantially less penetrated on their copper DSL footprint vs Windstream. Therefore, on their current EBITDA, there is much more gearing to the ramp in fiber penetrations; we think each of the 3 has the potential to increase EBITDA by 50% in the mid term and even double EBITDA on a longer term basis. Windstream, by contrast, should have more of a stable EBITDA trajectory on the current fiber build plan. This can be seen by simply comparing its terminal penetrations to its current broadband customer base: 2m FTTH target at 45% penetration is 900k, compared to its total 1.1m broadband customers today. As copper penetrations decline, Windstream may just tread water on its broadband subs (and notably, Windstream has flipped to net losses in the past couple of quarters, despite the ramp in fiber builds). Also, given Windstream’s relatively higher ARPU, the mix shift impact on ARPU from the copper to fiber transition in the sub base will have less of a positive impact. Kinetic does have an above average margin profile (high 40%), which partly speaks to its relative over-penetration in copper and is a risk, but does lead to better unlevered free cash conversion and therefore supports a higher EBITDA multiple in our view. So taking all of that together, we would value Kinetic at closer to a mature telecom multiple, which we view as 7-8x range on EBITDA and implied low to mid teens on uFCF.
2. The combined wholesale fiber businesses will do around $320m of EBITDA. Valuations for these assets are the subject of a healthy debate in the market. Private deals have tended to transact in the low to mid-teens EBITDA multiple. People with a more bearish view, however, have pointed out that these businesses only grow with a sizeable amount of capex, and very few if any have actually transitioned to a “steady state” where you can actually clearly see the topline stability along with FCF generation. This debate is playing out in the Zayo credit market currently…company is levered 8-9x with its secured debt trading in the low to mid teens yield range. On Windstream’s rumored sale of its wholesale fiber asset, apparently it was seeking a low double digit multiple, with another source indicating a wide valuation range of $1-2b. We can do some back of the envelope math, making simplifying assumptions on churn, to come to a semi-informed view on what the steady state E-Cx of these businesses could be. Windstream Wholesale is around $450m run-rate topline currently. We don’t know churn for this business, but they are mostly focused on the waves market, which tends to have higher churn…we have heard that 1.5% monthly is a reasonable estimate here. Call it 20% of its topline will churn in a given year, or $90m of revenue to replace. Capex paybacks here should be shorter, as you can sell new waves on your existing fiber routes, with the only capital outlay being optical equipment…assuming 6-12 months means ~$70m of steady state replacement capex required every year. So the Windstream business should do ~$130m of E-Cx steady state or around $100m uFCF. We would value that at only ~10x (~$1b of value), as this is an ex growth multiple in a competitive market, albeit one that is growing overall, and therefore there should be some assigned value to the opportunity to further deploy capital at attractive returns. On the Uniti side, its fiber business is more diversified across cell backhaul (~25% of revenue), enterprise/wholesale (~30%), dark fiber/small cells (~20%), and gov’t/E-rate (~20%), etc. and therefore its monthly churn is likely in the <1% range. Call it 10% annual churn against its $300m revenue base is $30m. Paybacks here can be a bit varied depending on the type of build / service offered, but 12-18 month paybacks would put steady state capex in the $30-45m range and therefore steady state E-Cx in the $75-90m ballpark / uFCF around $60-70m. We think this deserves a mid-teens or higher multiple, as there are more diversified end markets, a less competitive environment in the tier 2/3 markets where Uniti is focused in the southeast of the country, and a good chunk of the business is dark fiber (~20% of revenue but depending on the various margin profiles of the different end markets, could be >1/3 of EBITDA). So this business is also likely around $1b of value. Combining both Windstream and Uniti fiber businesses we have ~$2b total or around 7x EBITDA.
3. Non-Windstream leasing is another $80m revenue / EBITDA. This is pure leasing and therefore translates pretty directly to uFCF. A bunch of different smaller sale leaseback type deals and dark fiber IRUs comprise this revenue, with varying degrees of customer risk…we would put a LDD to mid-teens multiple on this, or another $1b of value.
4. The enterprise CLEC is the asset struggling the most and where we are most bearish. We would only ascribe value to the ~$100m floor of “strategic” EBITDA that is next gen. Usually capex for these businesses is ~10% of sales which would put E-Cx at $50m. While this comprises the most modern product sets such as SD-WAN, it is hyper competitive and the barriers to entry are getting lowered as it becomes easier to procure the last mile access to enterprises’ offices (exactly what SD-WAN is meant to do). On the other hand, Windstream is growing this part of the business nicely (we don’t know how much of this growth is just cannibalization however), and other enterprise businesses are getting disrupted too, so there is a market to go after. So we would only put a HSD/LDD multiple on this, call it $500m of value
5. Finally, there is the ~$80m of Windstream shared overhead, ~$20m of Uniti corporate overhead and ~$20m of Uniti leasing costs that we need to factor in (we are not sure what the split is of the latter between Windstream and non-Windstream leasing). There should be some overhead synergies in a Windstream + Uniti combination, but frankly we are not quite sure how to size them. We would make the simplifying assumption that the value of these shared expenses less any synergies might simply cancel out the value of the enterprise CLEC above.

Putting it all together gets us ~$11b of total value against $8.1b of total debt / $5.9b secured. The uns are therefore ~50-75% LTV. This compares to Frontier 2L at ~50-66%, Consolidated 1L at 0-78%, and Ziply in the 30-60% range. However, we would point out that this does not capture the potential value creation from BEAD subsidies / investment, and we think Windstream has the most attractive opportunity here.

Returns and downside protection:

While Uniti uns would be the highest LTV of the above mentioned comps, they are all around the same ballpark and we think the current mid-teens yield on Uniti could easily tighten to 10-11%. From the current price of high 60’s / ~15.5% yield on the 2029s, this would be a 1-year trade to the mid 80’s / 10.5% yield for a total return of ~30%. At 75c / 13.5% yield and 80c / 12% yield, this would still be a 1-year total return of ~20% and ~15%. Therefore, we would be comfortable buying up to 80c.

On why the opportunity exists, we think that Uniti & Windstream have been brushed aside by investors, both generalist/special sits and TMT analysts, with the former abandoning it due to the perceived lack of a catalyst (which might start to change now with the merger headline) and the latter preoccupied by the numerous other stressed/distressed TMT names in their universe. TMT analysts may even overlook the hidden BEAD-driven catalyst for a merger, since Uniti/Windstream is such a storied credit and they have grown skeptical of Uniti’s endless promises of strategic deals / diversifying M&A.

Quick note on downside protection. Like we mentioned earlier, we do not see this trade lasting beyond this year, so for the practical purposes of thinking about downside protection, it is really a MAD risk of Windstream/Elliott proactively blowing up the lease…we think this is a remote possibility. But even when thinking about the lease renewal downside scenario, we think there is value through the Uniti unsecureds, and is why we feel so comfortable with this trade and love the asymmetry offered currently. Windstream/Elliott have argued that the lease at renewal could come down to as low as $200m. A large chunk of this would be comprised of the Uniti fiber overbuild ($1.75b total investment at 8% + 0.5% escalator), along with other historical fiber overbuilds in Uniti’s states, and some small amount for remaining copper. We think this $200m, as it is majority leasing of fiber infrastructure, should be valued ~15x. Wholesale fiber deals globally have transacted at mid-to-high teens (even >20x). Granted those are typically full open access, whereas this is still single tenant, but still….this should represent super senior Windstream credit risk, so ~7% feels fair (~7.5% currently for single B yields, less 0.5% annual growth). This lease would therefore be around $3b of total value. Add in the $1b of current value for the Uniti fiber business we went through above (not even factoring in the future growth of this business) and $1b for non-Windstream leasing, brings us to ~$5b of total value. Uniti has ~$3.5b of secured debt today and $2.2b uns / converts. Even assuming additional secured issuance to $4b (further RCF draw, solving ’24 stub converts with secured, etc.), there would be $1b value to a ~$2b uns tranche. Restructuring math is never this simple, and we acknowledge that the uns would be fully equitizing in this scenario and likely trading at a discount to this ~50c of value, they might need to put up $$$ to defend their position and further delever the 1L to be FCF positive, etc. But this high level math to us shows that there would likely be value attributed to the uns in this scenario, and when you are buying down your basis over the next 4-5 years to <50c, it is not hard to see how you have pretty good downside protection even in this extreme.

Risks:

Lease blow up before renewal; as discussed, we think this is MAD risk and a remote possibility.

No deal and Uniti sells/spins off fiber business to the equity. While we have seen some public co’s in the high yield / distressed arena get more aggressive with liability management transactions, this team does not strike us as likely to do that sort of deal. More likely would be a straight sale and secured debt paydown in line with the asset sale covenant, which would be better but still might not be great for the uns, depending on the price.

Catalyst

Deal with Windstream