The Windstream / Uniti Mess

I’ve been fielding a lot of questions asking about the controversy between Windstream and Uniti. Most people seem to be fuzzy about the relationship between the companies. I’ll try my best to explain the mess that these two companies have created.

Windstream decided in January 2014 to spin off its assets into a REIT, which is a real estate investment trust, a formal kind of investment vehicle defined by law. A REIT generally owns real estate like apartment buildings, shopping malls, or perhaps specialty real estate like storage buildings or college dorms. REITs sell ownership shares to the public, similar to stocks. An investor in a REIT is making a real-estate investment while gaining safety by spreading risk across multiple properties. A REIT is generally expected to pay significant dividends.

Windstream was a traditional mostly family-owned regulated telco. Windstream moved its fiber and copper assets to a REIT owned by the newly-formed Uniti. In the split of assets, Robert Gunderman remained as CFO of Windstream while his brother Kenneth become CEO of Uniti. The Uniti REIT is attractive to investors because Windstream pays roughly $650 million per year in ‘rent’ to Uniti for use of the network. Since formation, Uniti has added other assets to the portfolio, but the Windstream assets still represent 70% of its assets.

The current mess was triggered when Aurelius Capital, a lender to Windstream, filed a lawsuit claiming that the REIT arrangement was a violation of Windstream’s corporate bonds. Windstream immediately filed for bankruptcy earlier this year when a judge ruled in favor of Aurelius Capital.

Windstream and Uniti immediately went to mediation to try to resolve the issues raised by the Aurelius Capital lawsuit. Recently it became clear that the two companies could not resolve the issues, and Windstream and Uniti are now going to court to decide the future of the REIT arrangement.

The court case is mostly going to have to resolve an accounting issue. At issue is the question of whether the payments from Windstream to Uniti are rent or if they are instead a disguised financing arrangement. This difference is vital to the survival of Windstream and Uniti. If the payments are rent, as Uniti maintains, then Windstream would have to pay rent before they make debt payments to Aurelius Capital and others. Further if the payments are rent then Wondstream would have to continue to pay Uniti to use the network. However, if the payments to Uniti are considered to be a financing arrangement, then those payments become unsecured debt and go to the end of the line in payment priority.

The ‘rent’ payments to Unity equate to a $6.9 billion long-term liability of Windstream. The company has another $4.8 billion in senior debt and $1.5 billion of unsecured debt. If a court decides that the payments to Uniti are rent, then the bankruptcy court is likely to erase some of the debt owed to Aurelius Capital and others. However, if the payment due to Uniti are unsecured debt, then a bankruptcy court is likely to erase some of the Uniti debt, which would put Uniti out of business.

Windstream would see a huge windfall if they could walk away from some or all of the Uniti payments – however, they’d be in the awkward position of not owning their networks. It’s hard to picture what happens to the networks if Uniti goes bankrupt.

There are several factors that the courts will use to determine if the Uniti payments are more like debt or rent. For example, rent is generally determined by fair market value of the property. The copper networks are nearing end-of-life and it’s hard to argue that the annual payments to rent copper shouldn’t be declining. However, the payments from Windstream to Uniti increase every year during the 35-year lease term. When examining all of the arguments made in this case, from an accounting perspective it seems that Windstream has the stronger arguments – but the courts will have to decide.

If Windstream is required to continue the full payments to Uniti, the telco will be cash-strapped for the foreseeable future. It seems that Windsteam feels confident they will win the lawsuit because they recently announced a plan to bring gigabit fiber to 60% of its customer base over the next 10 years, predicated upon getting out from under the Uniti debt payments. This means that the broadband future for a lot of communities rides upon the court deciding that the Uniti payments are debt and not rent.

Telcos and Taxes

windstreamWindstream recently got approval from the IRS to restructure their company and spin off their copper and fiber networks as a REIT. This stands for Real Estate Investment Trust, a form of investment that has been around since 1960. REITs were created by Congress as a way to bundle together income producing real estate in such a way as to create a marketable security.

By IRS rules, REITs must invest 75% of the value of their company in real estate assets, cash and cash equivalents and government securities. What the IRS has done with this ruling is to declare that copper and fiber networks are real estate. This seems like an odd ruling since common sense would tell you that copper and fiber are not real estate in the traditional sense.

The whole purpose for Windstream to do this is to avoid taxes. They estimate that being treated as a REIT will save them about $100 million per year in income taxes. Wall Street immediately boosted Windstream’s stock and also boosted the stock of other telcos on the assumption that they will all follow suit. The stocks of telcos, CLECs and cable companies rose on the news.

The number of REITs has grown significantly in recent decades. In 1971 there were only 34 REITs and by June of this year they have grown to 210. The classification of Windstream as a REIT is not without precedent since American Tower and all of its cellphone tower assets were classified as a REIT a few years ago. The IRS had recently clarified that the definition of real estate for purposes of REITs to include land, permanent structures and structural components. One can only assume that the IRS believes that wire networks are structural components.

Large corporate tax avoidance has been in the news lately with a number of corporations undertaking ‘inversion’ to become classified as foreign corporations to avoid paying US income taxes. In the last few weeks the Walgreens drugstore chain had announced that they were going to undergo inversion but then changed their mind after they got a lot of public pressure. Congress has been looking to close the inversion loophole.

And now, all of a sudden it is the telcos that are going to be avoiding taxes. I must say that this dismays me personally. For several decades I have tried to do my best to buy local and to buy American whenever I can. In my mind, an American company that refuses to pay its fair share of income taxes might as well be a foreign company and I try to vote with my pocketbook and boycott such companies whenever I can.

I’ve always felt that American corporations ought to pay their full share of income taxes just like the rest of us. The corporations that are taking advantage of these tax loopholes all became successful due to being in the US. It’s our American laws and the American business environment that helped these companies get started and thrive. It feels un-American when a corporation suddenly turns their back on all of us to save from paying their fair share of taxes. Obviously corporations are in the business of maximizing their return to shareholders, but at the same time I think corporations have a moral obligation to be good citizens and do their fair share to support the country that supports them.

I understand that there are multinational corporations that do business all over the world. It’s not entirely clear where a company like Apple ought to pay taxes since they manufacture their phones overseas and sell many of them overseas. But there is no ambiguity with a company like Windstream. All of their poles and copper and fiber are sitting in the United States and deriving revenues that are all from the United States.

I understand that Windstream has not taken the inversion option and declared themselves to be a foreign corporation. But they might as well have done so since they instead are taking advantage of a very questionable loophole that has the same effect as being a foreign corporation. The percentage of federal tax revenues that the federal government receives from corporations has dropped precipitously over time from a high of nearly 40% during the 1940s and projected to be only 13.5% for 2015.

I say shame on Windstream. This might be good for their shareholders as witnessed by the boost in their stock price after the announcement. But in the long run this is bad for the country and bad for all of us. If Walgreens had decided to take the inversion and declare themselves to be a foreign corporation I was prepared to move my pharmacy business to CVS. I’ve always voted with my pocketbook and I wish more people would do so. But it’s going to be hard to vote with your pocketbook if all of the major telcos declare themselves as REITs. Unfortunately the vast majority of us don’t have any options for telecom services other than these giant companies.