Description

Communications Sales & Leasing (CSAL) - $26

CSAL was written up by Fletch back in July, 2015 at around $22, with a target price of $32.  The stock surpassed his target last year, and has since sold off pretty dramatically to $26, creating a stock with an asymmetric risk/reward and a 9% dividend yield.

I won’t go into a lot of detail on the history and formation of the company, Fletch does a good job explaining this.  In short, CSAL was a spin-out of Windstream, a Rural Local Exchange Carrier - who at the time of the spin was over-levered and needed to cut its dividend.  Instead, it surprised the market and created a triple net REIT - CSAL - whereby they did a sale/leaseback of all the copper, fiber, electronics and distribution systems in the network to CSAL.  WIN levered up CSAL, took the debt off the shoulders of WIN, and retained a 30% stake in CSAL.  WIN has a 15 year lease for the network with CSAL, paying $650 million / year to the company, with a sad 0.5% / annum escalator starting after year 4.  For GAAP purposes, the revenue is recognized on a straight-line basis over the course of the lease.  Since then, Windstream has sold off or done debt exchanges to reduce its ownership in CSAL to 0 - while also diversifying its own business by announcing a deal to acquire Earthlink.  Windstream will see its leverage fall to 3.2x (from 3.7x) post the Earthlink acquisition which should close mid 2017.  

The risk to the CSAL payments from WIN is low - as CSAL is effectively the most senior lender to Windstream.  Even if WIN was forced to cut its dividend or even defaulted on debt, in order to keep the business operating it would still have to pay CSAL its $650 million / year through any bankruptcy.  Its also worth noting that any capital Improvements made to the network by Windstream, including overbuilt fiber, automatically become assets of CSAL under the master lease agreement.  As of the Q3 call, the CSAL benefitted from $181 mm of tenant improvements from WIN.

CSAL will continue to make acquisitions in 2017 - with a pretty robust pipeline of opportunities - including a potential deal with Windstream around the soon to be acquired Earthlink assets.  CSAL, originally laid out a business plan to diversify its business away from Windstream with a mid-long term goal of 50% diversification.  The company targets wireless infrastructure businesses - specifically fiber (dark and lit), wireless towers and wireless tower ground leases as well as other triple net sale/leaseback structures.  While the company was spun with 100% of revenue attributable to WIN, it is starting 2017 with about 20% of its business derived from external wireless infrastructure businesses.  A potential Earthlink deal would take them further away from diversification - but would add scale and potentially provide an opportunity to structure a transaction in a more beneficial way for CSAL, given it would now be at arms length, rather than at WIN terms.  It could allow them a more robust escalator, or additional growth opportunities.  

M&A

The company has made 3 sizeable transactions over the past year, 2 on the fiber side and 1 on the tower side.

FIBER - Uniti Fiber - $725 mm revenue under contract w 5.5 yrs left of term

• Acquired PEG Bandwidth in May, 2016 - $409 mm

• Customers include 3 of nation’s largest wireless carriers

• Company is focused on Fiber to the Tower including dark and lit fiber - weighted more towards lit services.  Largely success based capex, with 5% maintenance capex levels & 44% EBITDA margins.

• Network located in Northeast/Mid Atlantic, Illinois & South Central regions of US

• Deal was done at 13x LQA EBITDA including capital leases

• HSD top line growth in the NT, potential to accelerate

• Tower Cloud ($230 m + earnout)

• Deal was done at 12.4x LQA EBITDA

• Dark fiber and small cell provider to the national carriers - high % of rev from AT&T

• The 2 fiber companies are being combined, and expect $6 mm of run-rate synergies

• Comes with $60 mm of NOLs - and is under the TRS

• 34% LQA EBITDA margins; 5-6% maintenance capex

TOWERS - Uniti Towers -  Combination of small acquisitions + NMS

• Completed acquisition of 32 Windstream towers, in addition to the rights to construct and operate towers on approximately 1000 properties leased exclusively to Windstream

• Acquired Summit Wireless for $1.7 mm, effectively a management team with a small amount of built-to-suit tower contracts, and a small Mexican business - primarily with AT&T

• CEO of business was previously COO of American Towers’ Latam business and is now the head of Uniti Towers

• NMS - Announced on Q3 call for $65 million

• 359 wireless towers in Latam - including Mexico , Colombia and Nicaragua with 114 more in development that will be acquired upon construction.

• 60% of revenue is from AT&T

• Acquired for a hefty 18x multiple, with a initial yield of 5.5% in USD

• Targeting the built-to-suit opportunity in the US and as well as colocation in Latam as those countries roll out 4G.  

Mix of future deals in pipeline

• 61% fiber, 22% tower 13% tower lease and 4% consumer broadband.  The company keeps this updated in their slide deck http://investor.cslreit.com/Mobile.view?c=253961&d=4&v=100

• Deals could comprise whole acquisitions, sale leasebacks similar to that of the original WIN deal, as well as some combination thereof within a larger M&A transaction

• UpREIT Structure

• The company restructured the business into an UpREIT structure.  This effectively creates an operating partnership, underneath the public REIT, with membership units that are pari-pasu with the REIT equity.  

• All of the assets of the REIT pass through the operating partnership.  

• Issuing membership units to a potential target as currency, can make it non-taxable to the counterparty.  This structure could potentially help win transactions vs. other companies that have different capital structures.

Cost of Capital

• The company’s goal of lowering its cost of capital is a virtuous cycle based on M&A diversification causing stock price improvements and ratings upgrades, which gives them a stronger currency to continue to diversify.  

• Just over the past 4 months, the company has refinanced its term loan twice, bringing its interest rate down 100 bps on $2.1 bn of debt.  Most recently  was a week ago.  

• We would expect the company to continue reducing interest costs, and see debt upgrades at it diversifies its business further away from Windstream.  The rating agencies have conveyed a 25% diversification target as a credit improvement.  

• The current debt ratings are Moody’s B2, S&P B+ and Fitch BB-

Why the sell-off?

The stock traded off from a high of $32.73 it hit back in September to a low of $24 in November post election.  A few reasons we believe have led to this:  

• NMS transaction looks expensive.  The company, said that while it was a day 1 valuation of 18x EBITDA, it believed it would generate IRRs of over 20% before any scale or synergy benefits.  

• The stock rallied off the first 2 fiber deals, but on the announcement of the NMS transaction, it sold off as the street doesn’t believe there is enough opportunity or differentiation in the tower space to make NMS a viable competitor.  

• The company claims that the demand in the market will require 20,000 built to suit towers in the US over the next 5 years.  This seems implausible given that the big 3 tower operators currently have ~100,000 in aggregate and have said that the market is growing supply ~1% / year.  

• However, the company has stated they b/c they don’t have an embedded base of towers, they can be more creative on structuring deals.  The company clearly has a tight relationship with AT&T, on both the fiber backhaul, small cell and tower side in Latin America.  I believe the company will look to leverage that specific relationship to combine tower/fiber backhaul contracts so it gives AT&T a lower all-in cost, while still providing a solid return to the company.  

• The company also has exclusive rights to 1000 tower-zoned sites from Windstream, which have not been built out.  

• The company believes that there are clear synergies b/w owning a tower and fiber business, but its M&A pipeline is still heavily weighted towards the fiber business.  

• The NMS business came with Mexican Peso risk, at a time when the Peso was collapsing.

• Interest Rates

• Clearly, as rates have moved higher, the view is that REITs should underperform.  However, comparing the RMZ (REIT) index performance to CSAL from the middle of September, when the entire index turned over, shows that CSAL has underperformed the index by over 1200 bps as the 10 year moved from 1.7% to 2.4%.  THe RMZ is roughly flat on a total return basis, while CSAL is down 12%.  And since rates spiked post election, the RMZ is actually up 7.7%.  

• Clearly as rates move higher, and inflation moves higher the company will not be able to pass inflationary increases on its WIN lease, and the capital markets will become more expensive.   However, an improving credit profile, and lower cost of equity will overcompensate for interest rate pressures in the near-mid term.  

• WIN performance

• There is also the simpler explanation that CSAL is trading in line with Windstream.  During the same time period as described above (from 9/15/16 to present), the stock charts have tracked each other.  WIN is down 18%, while CSAL is down 14%.  This doesn’t make a ton of sense given that CSAL is effectively a creditor of WIN and WIN credit spreads have improved over the same period of time and improved dramatically since the start of 2016.  We would expect this to decouple over time.  

• Undercovered by sell side and under-owned by REIT investors

• CSAL is covered by 7 sell-side analysts with a market cap of $4.1 billion and ADV or $31 million, while WIN is covered by 12 with a market cap of $700 million and ADV of $13 million

• Short interest of CSAL is 1.7%; short interest of WIN Is 25%

• The company is largely owned by Telco investors, and covered by Telco sell side analysts.  It is the only pure telecom REIT, making it likely a high hurdle for REIT dedicated investors.

Valuation

The business is not sexy, but it is an orphaned asset, trades with a 9% dividend yield, 10x AFFO and 11.5x EBITDA.  The Triple Net REITs - the closest comparable -  trade at a 5.3% dividend yield, 15x AFFO and 17x EBITDA.  WIN has a dividend yield of 7.5%, 150 bps inside CSAL despite its dividend being subordinated to the lease payments owed to CSAL.  Further, WIN 5 year debt trades at 7.8%, 120 bps inside CSAL dividend yield and 130 bps wide of comparable CSAL debt at 6.5%.  As mentioned before, this is important to note b/c as I mentioned above because CSAL effectively is a senior lender to WIN.

Ascribing a 7% dividend yield, and 13x AFFO multiple - still a large discount to the Triple Net REITs, the company would be at $34.50, and provide a total return of 39%.  If it could trade to 14x with further diversification (I don’t factor in any additional M&A), it would be a $37 stock, with a 49% total return.  

Catalysts

• Over the course of the next year we should see a continued stream of acquisitions including  a decision on the Earthlink assets by WIN/CSAL. With the continued diversification and revenue growth profile, will come a better credit rating, continued debt refinancings can lead to a lower cost of capital, accelerating AFFO growth

• Most importantly, this could lead to a GROWING dividend policy - currently it is stable at $2.40, but the company hopes it could turn into a growing dividend over time  

• Overall telco industry consolidation should help the multiples within the sector.  This is likely to continue the trend we saw last year, especially under a republican hands-off FCC.

• Strong results in the fiber assets.  While Zayo at the Citi conference and today on its earnings call described a slowing of bookings due to industry consolidation and overall uncertainty around 5G and taxes, CSAL stated at the same conference that in fact they have seen strength in their fiber business

• Additional sell-side coverage will help.  Additionally, AFFO #s should increase just with the Term loan refinancing this week

Risks

• Large deterioration in Windstream business, including botched Earthlink acquisition which lowers the credit profile of Windstream.  

• Overvalued M&A - particularly in the tower space.  The market is looking for diversification but needs to see purchase discipline.

• Street modeling is all over the place. It is surprising because it is a relatively easy company to model, yet sell side #s have a wide standard deviation (2017 EBITDA estimates range from $279 to $340) - could add volatility to the name around earnings

• Poor performance in tower/fiber business

• Over equitizing deals - there will be some equity used in transactions. The company currently is at 5.7x EBITDA - which it is comfortable with

Catalyst

• Over the course of the next year we should see a continued stream of acquisitions including  a decision on the Earthlink assets by WIN/CSAL. With the continued diversification and revenue growth profile, will come a better credit rating, continued debt refinancings can lead to a lower cost of capital, accelerating AFFO growth

• Most importantly, this could lead to a GROWING dividend policy - currently it is stable at $2.40, but the company hopes it could turn into a growing dividend over time  

• Overall telco industry consolidation should help the multiples within the sector.  This is likely to continue the trend we saw last year, especially under a republican hands-off FCC.

• Strong results in the fiber assets.  While Zayo at the Citi conference and today on its earnings call described a slowing of bookings due to industry consolidation and overall uncertainty around 5G and taxes, CSAL stated at the same conference that in fact they have seen strength in their fiber business

• Additional sell-side coverage will help.  Additionally, AFFO #s should increase just with the Term loan refinancing this week