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Some history
Not all readers may have followed the battle between Uniti Group Inc. (NASDAQ:UNIT) and Windstream Holdings, Inc. (OTCPK:WINMQ), so let’s first step back and get everybody on the same page. Back in 2015, we had a sale and lease-back transaction in which Uniti Group was split off from the telecom company Windstream. Most of the cable assets, fiber and copper, were transferred to Uniti and then leased by Windstream under a fifteen-year lease contract, until 2030, with three five year renewal options.
From the Wallstreet Journal in October 2021, we learned of takeover rumors for both Windstream and Uniti to be taken over by a group around Zayo Group LLC. The rumor was that Zayo was prepared to pay $15 per share for Uniti. Uniti responded and argued that this price was far too low, as it should be in the range of $20-30 per share.
In November, Windstream surprised the market by starting a public debate with Uniti about its expected renewal rent as per the first renewal date in 2030. Windstream argued that the annual lease rent would come down, from currently around $700 million, by over $400 million per annum, so less than half. Implicitly, Windstream management was saying that they had the valuable assets, not Uniti, and therefore the $15 was more than enough.
The investors were left guessing which of the parties had the best argument, which was reflected in my two previous articles. In the first article, I stated both parties didn’t come up with very strong arguments, but I gave Uniti the benefit of the doubt. In the second article, I realized the issue at stake was more complex, and basically both parties had made a material error in the lease contract. Now Windstream turned out to have the best argument, but Uniti could easily force Windstream to jointly repair the contract such that Uniti prevailed.
We will now see whether Uniti indeed intends to repair the master lease contract with Windstream.
The JP Morgan conference
On 25 May, Uniti CEO Kenny Gunderman attended a JP Morgan conference during which analyst Philip Cusick of JP Morgan asked some very relevant questions regarding the lease dispute with Windstream (see the appendix for a somewhat longer transcript).
Cusick’s second question was right about the lease dispute with Windstream. Gunderman reponded:
Our MLA’s [Master Lease Agreement] with Windstream have fair market value resets in 2030 which is very common for MLA’s for REITS. In fact it is actually a requirement to get a true lease opinion to have a fair market value reset in 10 years. So, our MLA’s are no different from that.
Of course, we want to know whether this is true, and we will get to that later. A very relevant question is how Gunderman thinks to resolve the issue:
Cusick:
Is there any point in discussing the differences between your view and their view with Windstream? I think it is eight years from now when this is actually gonna…
Gunderman:
I think that, no, I think the answer is no because in reality <pause> hmm, this is not going to be a negotiation, there is a framework to follow, to set the renewal and it is prescribed in the 2020 MLA.
[…]The real question is why are we discussing this now, especially if it is not a renegotiation in seven or eight years and that is a question I think for Windstream.
So, no, CEO Gunderman doesn’t see the value of discussing this with Windstream, as the framework in the MLA is, according to him, clear.
And then the question comes up why this is all playing out in front of us:
Cusick:
I mean that what many of us think is that somebody wants to buy both of you and splitting the value between you in one direction or the other is very much predicated on this. Does that make sense?
Gunderman:
I think, that is a theory, and I think if that theory were true it would make sense that there could be parties who are interested in causing this debate and forcing me to have this Q&A in front of this room full of people.
So, Gunderman plays the victim.
The Master Lease Agreement (MLA)
Let’s have another look at the MLA and check whether Gunderman is right**. Is the renewal rent as per 2030 indeed set in stone? Exhibit E of the MLA defines the lease renewal rent and we read (please refer to the appendix for the full text):
All bold by the author.
“Exhibit E
This exhibit sets forth the framework that shall be utilized by the Appraisers in determining the Fair Market Rental for each Appraised Facility.”
So there is no discretion left, this is the prescribed framework and Gunderman is right on this.
“Definitions, for purposes of this exhibit:
Fair Market Rental – The rental price that a willing renter and a willing landlord, with neither being required to act, and both having reasonable knowledge of the relevant facts.”
Any real English speakers, not me, who immediately see the problem? Sorry, it took me a while. The above is all what Gunderman is referring to when he talks about a prescribed renewal rent at fair market value. One more time:
“The rental price that a willing renter and a willing landlord….”
Then nothing. This is not even a correct sentence. A willing renter and a willing landlord what? This sentence doesn’t tell us anything. So it certainly doesn’t tell us what willing renters and willing landlords agree upon, for instance entering into a lease contract at a fair price*. If this goes to court the judge now has an extra hurdle to decide what the real contractual intent was of the parties.
But it gets worse, as the definition of Fair Market Rental continues and basically comes up with a new, very different, definition:
“Calculation of Fair Market Rental shall be based on the following inputs determined by appraiser:
Fair Market Rental Formula
Fair Market Rental = PMT(rate, nper, pv, [fv], [type])
rate = Fair Lease Rate
nper = Renewal Term
pv = Fair Market Value – Residual Value
fv = 0
type = 1 (lease payment due at beginning of period)”
As we have previously seen, this formula is off-market, i.e., does not define a fair market rate, since subtracting the residual value from the initial principal balance can lead to crazy outcomes. This formula should be repaired.
So we now have basically two conflicting definitions of Fair Market Rental, of which one doesn’t make sense and the other is wrong.
Conclusion
There is a dispute between Uniti and Windstream on a very large, currently $700 million rent per annum, lease contract. The dispute is about the question how that rent will reset as per 2030. We have a Uniti CEO in front of us who continues to claim that it is all set in stone and we should have nothing to worry about.
After looking carefully into the lease contract, we realize the contract is very poorly drafted and, on top of that, contains a material contradiction. Uniti’s position is even worse than we thought. It has become high time that CEO Kenny Gunderman starts to act and repair the contract.
* Now I realize that I can even add the 2015 transaction counsel, Skaddden, Arps, Slate, Meagher & Flom LLP, to my SEC complaint. But maybe I should add Uniti’s 2020 counsel as well, Davis Polk & Warrdwell LLP. I must confess I lost count of the many very well paid “advisors” who could not draft a proper document. (Remember, we already had JP Morgan, Bank of America, Stephens Inc and Ernst & Young.)
** Remember that Gunderman was both advisor in the 2015 sale and lease-back transaction at Stephens Inc., and later became the CEO of Uniti and signed the MLA.
Part of the Transcript of the JP Morgan conference:
Gunderman:
Our MLA’s with Windstream have fair market value resets in 2030 which is very common for MLA’s for REITS. In fact it is actually a requirement to get a true lease opinion to have a fair market value reset in 10 years. So, our MLA’s are no different from that. Secondly, we reset our MLA’s with Windstream in 2020. As you know, so there was the original deal in 2015 and then we reset those MLA’s in 2020 when Windstream went bankrupt and we recut those deals in a mutually beneficial renegotiation. And so our disclosure on what we think the fair market value reset is gone be in 2030 actually stems from that reset in 2020. So we had an appraiser come in and assess the fair market of the rent and we also had them assess what they thought the renewal rent would be estimated to be in 2030.
And what we disclosed a couple of quarters ago was just that; we just basically took the disclosures from that appraiser and showed that to our investors, at least the outputs of it. That is important because that report predated the past six months of back and forth, so we actually think that gives it a little more credibility. And when you look at that estimate there is really a lot of moving pieces in an appraisal of this type but really probably the biggest assumption is hey copper is a depreciating asset, I think everyone recognizes that, but how quickly will it depreciate, and more importantly, how much will the fiber investment that we are making in that network overcome the depreciation of that copper. In our view, and the appraiser’s view is it will more than overcome the depreciation of the copper. It makes sense intuitively, copper is a kind of a five times valued asset, five and a half times valued asset, fiber these days is value at fifteen to twenty times. So we think with the investment that has been made in the network that in ten years our estimate of the rent is roughly flat compared to where we think it would be pre renewal. And so, again we can’t predict with certainty but that based upon the appraisal that was done back in 2020 versus our views of the trends in the business we think rent is gone be roughly flat.
MLA Exhibit E
Exhibit E
FAIR MARKET RENTAL CALCULATION
Landlord or Tenant, as applicable, will identify the Facilities from Exhibit A of this Master Lease that will be subject to appraisal, each such Facility being referred to herein as an “Appraised Facility”. This exhibit sets forth the framework that shall be utilized by the Appraisers in determining the Fair Market Rental for each Appraised Facility.
Definitions, for purposes of this exhibit:
Fair Market Rental – The rental price that a willing renter and a willing landlord, with neither being required to act, and both having reasonable knowledge of the relevant facts. Calculation of Fair Market Rental shall be based on the following inputs determined by appraiser:
Fair Market Rental Formula
Fair Market Rental = PMT(rate, nper, pv, [fv], [type])
rate = Fair Lease Rate
nper = Renewal Term
pv = Fair Market Value – Residual Value
fv = 0
type = 1 (lease payment due at beginning of period)
Fair Market Value – Shall be consistent with the meaning in IRS Regulation Section 20.2031- 1(b) and will reflect the premise of in-continued-use. Fair market value is defined as the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.
Residual Value – The uninflated future value of the Appraised Facility as of the expiration date of the Renewal Term, but in any case shall be based on IRS guidelines and methods consistent with that of lease transactions.
Fair Lease Rate – The rate of return used in the determination of the Fair Market Rental. The Fair Lease Rate shall be supported in Appraiser’s report by market comparable rates of return which may include analysis of a variety of factors including the Landlord’s weighed average cost of capital, the risk free rate of return, financing terms, asset/equity returns, and a market based risk premium.
All other capitalized terms shall have the meaning set forth in the Master Lease Agreement, unless otherwise defined herein.
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