UNIT - Uniti: CCC Spreads And A Great Point To Exit (Rating Downgrade)

2023-12-20 10:00:00 ET

Summary

• UNIT stock outperformed the S&P 500 with a 21.25% return since our last article, but the bonds almost kept up.
• The REIT's FFO estimates have been trending down, and 2024 looks to be another negative free cash flow year.
• Only one outcome will improve your odds of not losing money, and we are not too optimistic about that.

On our last coverage of Uniti Group Inc. (UNIT) we summarized the current conditions and told you why we felt the bonds were a superior bet on the company. We go over the performance of that suggestion and tell you why this might be a great point to exit the stock and the bonds.

Performance

UNIT stock did leave the bears in the dust since our last article with a scintillating 21.25% return profile. This beat the S&P 500 ( SPY ) as well, by a large margin.

While we did not have a Sell rating here, the performance was certainly not what we expected. That said, our view was that even the most optimistic of investors would do better to go up the capital chain and stick with bonds. The ones we alluded to were at $58.63 back then.

Those have also rallied and delivered a total return of 18% inclusive of accumulated interest.

So the relative hit was not too bad, all things considered. We now will tell you why we are moving to a "Sell" on both.

Key Developments

UNIT's Q3-2023 was filled with "solid recurring growth" as per the slide deck. What it did actually look like was a marginally higher revenue number that you needed to strain your eyes to see. Slightly higher EBITDA was also in the same vein but adjusted funds from operations (AFFO) dropped.

The company updated its outlook for 2023.

Compared to 2022, AFFO will now come in about 20% lower with all other metrics remaining constant.

One thing that most investors might miss is just how much the guidance has come in over the last few months. On most sites you can find estimates for FFO but not AFFO. But even that is useful for the delta. Here are the numbers from early October, where you can see projected FFO of $1.07 for 2023.

Below are the numbers for today.

So if you combine this information for UNIT alongside the big rally, you can safely say that UNIT is about half as "cheap" as it was 3 months back on 2023 numbers. That is of course if you used the FFO. UNIT tends emphasize the AFFO number and there is a pretty vast chasm between the two. You can see it by examining all the items that are added back to get AFFO from FFO. In most REITs, FFO tends to be higher than AFFO but this one is pretty unique.

You have to decide looking at the slide above which one you think is really representative of the earning power. In our view, adding back transaction costs (which seem to recurring) and non-real estate depreciation seems excessive. For the latter, we would keep in mind that UNIT is spending massive amounts of what it calls "success based capex".

In comparison, only $8 million is classified as maintenance capex. The company is also always financing and refinancing. So amortization of deferred debt discount and early repayment costs are not the best add backs. So our view remains that both FFO and AFFO vastly overstate owner's equivalent earnings and this will likely be a problem as we get into the next part of the economic cycle.

Outlook

You can argue about the potential for UNIT to create long term success but the company has some serious hurdles ahead. The most important one is that its credit quality (is rightfully) rated poorly. The unsecured debt is rated in the "Cs" and you can essentially see the stock has been yoyoing (in reverse) with where the High Yield CCC or below option adjusted spread, goes.

The best time to buy this is when you believe that the spread is topping and the conversely the best time to sell this is when this spread is about to bottom. It is our view that this "soft-landing" myth will play out like the previous "soft-landing" fantasies. The most probable case based on the degree of inversion of the curve is a "hard-landing" and of course it remains possible that we may have to actually get to another tightening cycle. Neither of these will be kind to UNIT. So in our view, you really don't want to own UNIT with negative free cash flow and tons of refinancing over the next few years.

Verdict

We think the high yield spreads are now close to their bottom levels. This is a good time to take profits in junk bonds and by extension dump stocks like UNIT. As we look ahead to 2024, the company will still have negative free cash flow after capex and after dividends. Estimates are for about $400 million in operating cash flow and close to $350 million in capex. Assuming dividends are maintained at 60 cents a share, it is easy to see how debt could actually go up again next year. So there won't be any deleveraging in 2024 and the re-financings will be at the doorstep.

Owning UNIT here is thus an explicit bet on a very soft and fluffy landing. We don't think the odds suit investors as even in that best case, upside seems modest with a primary tenant constantly whining about unfair lease terms. We are hence moving this to a Sell and think investors would be better off pursuing undervalued REIT related opportunities elsewhere.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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