Wall Street can be a complicated place where it is sometimes hard to figure out exactly who is benefiting from what. That's a vague warning, but the relationship between bankrupt telecom Windstream (OTC:WINMQ) and infrastructure real estate investment trust (REIT) Uniti Group (NASDAQ:UNIT) helps to highlight the problem.
Here's what you need to know about the recent lawsuit this pair of intertwined companies agreed to settle, and why it should be viewed as a warning about existing and future REIT spin-offs.
One way to raise some cash
Many companies own the properties they operate. This provides a benefit because they don't have to worry about rent and they know the asset is theirs to do with as they see fit (by adding expansions, for example). However, these buildings sit on the balance sheet and tie up capital that could potentially be used in other ways. It is easy to argue that selling such assets to raise cash that could be invested in the company's revenue-generating operations would be a better use of shareholder capital. Other times, selling such assets is simply a way (perhaps one of the only ones available) to raise the cash needed to reduce leverage.
Obviously the former is better than the latter here, but the general idea is basically the same: Sell property to raise cash for other purposes. One way to do this is to create a real estate investment trust to own the properties. This removes the need to find a buyer because the company basically creates one from scratch. And, usually, the newly created REIT has just one major tenant, which gives the former owner of the assets a lot of sway over the new owner. Creating a REIT like this is a common approach, but one that investors need to view with a healthy amount of skepticism.
Obviously, to get such a spin-off done, it needs to be pitched to investors in a positive light. If it isn't seen as a good deal for everyone involved, few will be willing to own the new REIT. Only not every REIT spin-off works as well as originally advertised. Uniti Group and its legal tussle with Windstream is a good example of the risks.
An example of a bigger problem
Windstream is a telecommunications company. It owned a significant amount of fiber optic cable (and other physical assets) but was basically a service company at its core. Since it had amassed a significant amount of debt building its business, it decided to create a REIT to own the fiber. In 2015 it spun off REIT Communications Sales & Leasing, which in 2017 changed its name to Uniti Group. That gave Windstream access to much-needed cash, and investors the ability to directly own the fiber via the REIT. Windstream touted the benefits of the deal (debt reduction) and the new REIT expressed excitement about its future.
Not everyone was pleased with the spin-off, however, with some bondholders claiming that the deal violated key debt covenants. Another problem that soon came to the fore was that one customer accounted for the bulk of Uniti's revenue -- something Uniti itself quickly complained about. That problem became a very real financial issue when, despite the cash infusion, Windstream filed for bankruptcy in early 2019. Interestingly, Windstream decided to take a much different view of the spin-off while in bankruptcy than it had when it was executing the transaction. It started calling it a financing transaction and basically wanted Uniti to take a haircut just like bondholders.
You can't argue with that take on the situation since it is fairly accurate to view the spin-off as a way for Windstream to raise cash. Uniti and Windstream eventually came to an agreement in which Uniti's rents remained roughly the same. But there was a cost: Uniti had to agree to sell 33.6 million shares to Windstream bondholders, buy additional assets from Windstream (for a total of around $40 million), and pay Windstream nearly $500 million (including interest) over five years, ostensibly to get itself released from any liability related to Windstream's bankruptcy filing. That's not a great outcome for Uniti or its shareholders.
Uniti shares initially surged on the news, but are now below where they were prior to the settlement. While that's partly because of the COVID-19-related bear market, even if Uniti had held some of the gain it would still be trading well below its price when it was spun off from Windstream. Uniti has not been a particularly good investment for shareholders.
But this isn't the only example of a problematic REIT spin-off. Seritage Growth Properties (NYSE:SRG) was spun off from Sears Holdings to raise cash for the struggling retailer. From day one, Seritage was working to reduce its reliance on troubled Sears and Kmart stores. Sears' eventual bankruptcy, however, left the REIT with little choice but to eliminate its dividend so it could continue its efforts to redevelop and release former Sears and Kmart properties. COVID-19 business shutdowns, meanwhile, could make life difficult for Gaming & Leisure Properties (NASDAQ:GLPI) to collect rent from its former parent, casino operator Penn National Gaming (NASDAQ:PENN), which accounts for around 80% of its rent roll. You can't blame Penn National for the impact of COVID-19, but Gaming & Leisure's highly focused tenant base is a direct result of the spin-off.
The key takeaway
You get the idea. While all of these REITs may eventually work out to be good companies over the long term, the risks that came along with the spin-offs that created them need to be considered carefully. In the short term, such REITs are often beginning life with one major tenant that could very well be dealing with excessive leverage or other financial headwinds. It is a problem that shouldn't be ignored, even though the spin-off is likely to be hyped as a win/win for everyone involved. If something goes wrong, which happens every now and again on Wall Street, investors in the REIT are likely to take a hit. Granted the Uniti case is uniquely bad, but it sheds a light onto a larger trend that investors ignore at their own risk.