Description

We recommend purchasing the 6 3/8% Windstream (“WIN”) unsecured bonds of August 2023.  The bonds are currently available at 59, with a yield to worst of 19-20% pricing in an imminent default due risks associated with the litigation with the hedge fund Aurelius Capital Master Ltd.

The bonds are a liquid ($1.15 billion in Notes outstanding), attractive risk reward play on Windstream prevailing in the litigation.

Should Windstream prevail, we believe the Notes will trade up 10-20 points (which is where they were trading before the litigation commenced) as the Company’s current exchange offer should push out any potential chapter 11 event to 2021 if not further.  Should Windstream lose (and get the court to stay acceleration pending appeal), we expect the bonds to remain around where they trade now which is a 19% yield which prices in obvious risk of default should the Company’s operations not stabilize.

Key Dates

Aurelius trial set to begin Monday, July 23rd

Exchange offer expiration Thursday, July 26th

Q2 2018 Earnings:  August 9th

Aurelius Trial Decision:  sometime between Monday August 1, 2018 to February 28, 2018

Corollary Securities

WIN equity

WIN 2nd lien debt

UNIT equity

UNIT debt.

The trial hinges on two concepts:

Was the 2015 Uniti Transaction a Sale and Leaseback Transaction as defined under the Indenture and so not permitted?

Was the November 2017 exchange offer and consent solicitation conducted properly and are the New August 2023 Notes Additional Notes under the Indenture?  If so, the result of the consent solicitation that waived any Event of Default related to the 2015 Uniti Transaction would be valid. If not, depending on the outcome of #1, above any Sale and Leaseback Transaction violation of the Indenture would have matured to an Event of Default.

Background

Company Description

Windstream is a struggling telecommunications company that was formed in 2006 from the merger of VALOR Communications (GTE Southwest) and Alltel’s legacy landline business which has since grown through acquisitions.  Windstream has large Residential, Small Business, Enterprise, and Wholesale businesses with a significant portion of the business dependent upon legacy services such as voice, long distance, and DSL which as everyone knows are in secular decline.  Parts of Windstream’s business is rural in nature providing some natural moat from broadband cable competition.

In 2015, Windstream’s Operating Company called Windstream Services (here “Services”) contributed roughly 66,000 route miles of fiber and over 234,000 route miles of copper cable lines, central office land and buildings, beneficial rights to permits, pole attachment agreements and easements and a small competitive local exchange carrier into a new company now called Unity.  In exchange for those assets Uniti transferred to Services: 1) 100% of Uniti’s common stock, 2) $1.035 million of cash, 3) $2.5 billion of Uniti debt (term loans and secured and unsecured notes). Services then distributed 80.4% of its new Uniti stock to its parent company Windstream Holdings, Inc. (here “Holdings”) which distributed those shares to its shareholders in a spin-off transaction.  In conjunction with the spin-off, Holdings (but not Services) signed a fifteen-year lease with Uniti to lease the assets Uniti had acquired from Services for $653.5 million per year. Holdings also reduced its common stock dividend from a run rate of approximately $650 Million per year to approximately $60 million per year. It is this transaction which is the subject of the purported violation of bond Indenture’s prohibition against Sale and Leaseback Transactions.

In 2017 Windstream acquired Earthlink which was a combination of Enterprise Services, Fiber, and legacy dialup internet access for 100 million shares of stock (doubling the share count) and $435 million debt assumption.   In 2017 Windstream also acquired Broadview which is more enterprise focused. With the Earthlink and Broadview acquisitions the sum of the 2016 parts would have generated approximately $2.3 billion of EBITDAR. Windstream is projected to generate approximately $2 billion of EBITDAR in 2018 underscoring the rapid decline in Windstream’s voice, long distance, and DSL services.  While Windstream is investing heavily in new assets and capabilities (between $500 million and $600 million above “maintenance cap ex” per year the past several years) and management projects EBITDAR to begin growing again in 2019, the expectation of most observers is that Windstream will continue to lose share to cable broadband, cell phones, and enterprise competitors such as Level 3 and Zayo.  Due to the heavy capital expenditure budget and large lease payments to Uniti, free cash flow is running less than $200 million annually.

One need only look at today’s Citicorp downgrade to sell (with a $1 target) of the Windstream common (he also downgraded the UNIT common to sell as well) to get a take on the conventional wisdom that the Company is not long for this world (two tin cans and string is how some bears have described the legacy businesses). For those who want to take a more leveraged bet on a positive litigation outcome, the equity has only about $150mm of capitalization beneath an almost $6 billion debt stack. It is not hard to see how the option value of the common would be greatly enhanced by both successful litigation and exchange offers.

Windstream is highly levered.  Total Debt is about $5.88 billion.  Net Debt around $5.83 billion versus about $1.34 and $1.3 billion of projected of Expected EBITDA in 2018 and 2019.  Making the company about 4.4x levered. Assuming $200 million - $300 million of dark fiber sales (non-EBITDA generating), EV/EBITDA would decline to about 4.25x.  Putting an 8x multiple on lease payments, Windstream is about 5x EBITDAR which is the right way to compare it to comps such Frontier, and Centurylink.

Current Events

A hedge fund, Aurelius Capital Master, Ltd. claimed last September that Windstream Holdings, Inc., a struggling telecommunications company had violated a bond indenture when Windstream Spun-off a subsidiary called Uniti.  At question is whether, Windstream Services (Windstream Holdings’ operating company the and borrower on the notes) entered into an impermissible Sale Lease Back Transaction.

Whether the transaction violated the Indenture contract will be decided by the U.S. District Court, for the Southern District of New York in a trial starting July 23rd.  The Court will also address whether the exchange offer Windstream orchestrated in November and December last year was permissible under the Indenture and thus whether the waivers of default Windstream obtained stand.

Interestingly, at the time of the Uniti transaction (announced 2014, consummated 2015) there were no challenges to the deal.  Maybe bondholders were sanguine given the large debt pay down they received from Uniti and Windstream’s large dividend reduction.  Also, legacy telecom results and expectations were, at that time, not so bleak.

Aurelius’ >25% position in one series of bonds gave Aurelius the right to declare a Notice of Default, which it did on September 21, 2017 alleging a breach of the indenture, which if true and if not cured in 60 days would ripen into an Event of Default.  Such an Event of Default, would trigger acceleration of the August 2023 notes as well as cross defaults and acceleration of all of Windstream Services’ secured and unsecured loans and notes.

Specifically, Aurelius alleged a technical Event of Default related to the spin-off in 2015 of a Services subsidiary now called Uniti (the “Uniti Transaction”).  Aurelius alleged and continues to allege that the Uniti spin-off was a Sale Lease Back Transaction that violated the covenants limiting Sale Lease Back Transactions in the August 2023 Notes Indenture.

While Aurelius will not disclose its trading history in the August 2023 Notes nor admit whether it has any CDS position in Windstream Services or Uniti debt, nor admit whether or not it has any short position in Windstream Holdings or Uniti common stock, the conventional wisdom is that Aurelius has a large Windstream CDS position, may have a Uniti CDS position, probably had a short position in Uniti common stock and may have had a short position in Windstream common stock.  No one believes Aurelius was a Windstream bondholder at the time of Uniti Transaction. It is clear that Aurelius intended to profit off of chaos in Windstream related securities prices as well receive a windfall profit from a Windstream Event of Default. Whether such an event threw Windstream into bankruptcy was not Aurelius’ concern.

Windstream, in the face of the Aurelius letter has been confident that no default has occurred.  The capital markets, however, have not known what to think. As such, faced with uncertainty (and locked out of the capital markets), Windstream looked to moot the issue by obtaining waivers from its bondholders, which it needed from each series of Notes outstanding.  The only problem was Aurelius had built up its ownership of one series of bonds to over 50% such that it controlled the vote and could block a waiver. Cornering the silver market to manipulate prices is illegal, but apparently cornering the market in a bond to do the same thing is not (or at least the issue hasn’t been addressed by regulators, but perhaps it should be). 

Fighting for its life, Windstream with the help of Citibank organized an exchange offer whereby they offered 2021, 2022 and April 2023 maturity, 7.5% coupon bonds the ability to exchange into the August 6 3/8 coupon August 2023 bonds that Aurelius controlled, thereby diluting Aurelius’ corner and blocking position and setting the table for a consent solicitation (vote) by the new larger bond group of bondholders to waive any potential default, thereby avoiding a bankruptcy.  Approximately, $511 million of bonds were exchanged for $551 of New August 2023 Notes. Almost 70% of the new total of August 2023 Notes consented to waive the Sale Leaseback Default. Tellingly, over 50% of the non-Aurelius old August 2023 notes voted to waive the Default. The Company brought a gun to a gun fight.

The trial that starts Monday will also cover whether that exchange offer, which resulted in Windstream’s debt increasing by $40 million was allowed by the indenture and as such, whether those votes count.  

Issue #1.  Was it a Sale and Leaseback Transaction?

Windstream says no.  The Indenture says a Person (i.e. Services) must both sell and lease back the assets.  In this case Holdings (which is the parent or an Affiliate of Services) leased the assets from Uniti and allows Services to use them.  Skadden blessed the Transaction at the time. The transaction was announced in 2014 and completed approximately 9 months later in 2015 with no challenges by rating agencies or bond investors.

Aurelius insists the “Person” argument is a distinction without a difference and given Services cannot provide its services without access to the Uniti Assets, is investing maintenance cap ex in the assets, and paying dividends to Holdings which Holdings is using to pay the lease, the Lease is constructively Services’.

Our guess is that it is 50/50 that the Judge will on the Sale and Leaseback Question.  Furman, the judge here seems focused on the language of the contract. If you just look at that, Windstream probably prevails.  We do think it is possible that Furman rules against Windstream on the Sale and Leaseback Issue, but then expect him to rule in favor of Windstream in Issue #2

Issue #2 Was the Exchange offer Permissible under the Indenture

The Indenture says that (if the Uniti transaction is indeed ruled a “Sale and Leaseback Transaction” under the Indenture) Windstream may have only increased its debt if

the amount of such Permitted Refinancing Indebtedness does not exceed the amount of the Indebtedness so extended, refinanced, renewed, replaced, defeased or refunded (plus all accrued and unpaid interest thereon and the amount of any reasonably determined premium necessary to accomplish such refinancing and such reasonable expenses incurred in connection therewith) (emphasis added)

The parties are arguing over the word “premium”.  Was this $40 million paid to the exchanging noteholders a reasonably determined premium necessary to accomplish the exchange offer?  If not Aurelius insists the votes did not count, the technical default has matured into an Event of Default and they (and all other bondholders) are due the principal (plus default interest) of their bonds immediately (potentially resulting in a Windstream bankruptcy).

The word “premium” is not defined in the Indenture but is generally used throughout the Indenture to mean a payment in excess to the principal amount of the Notes.  The term Applicable Premium is specifically defined referring to the make-whole payment to compensate bondholders for lost economics in the case of an early redemption.  I see the fact that there is a defined type of premium payment, but also undefined uses of the word premium, suggesting that premium can mean different things in different situations.

Windstream goes to great length in its court filings to explain how most of the $40 million in additional Indebtedness was “compensation” to noteholders to exchange from an earlier maturity, higher coupon bond into the later maturity (and thus riskier), lower coupon August 2023 notes.  But for some reason Windstream was initially loath to call it a premium and argued obtusely that because the fair value of the Notes was similar the different principal amount of the notes were actual the same “amount” of Indebtedness. I am inclined to agree with Aurelius that this argument does not stand a good reading of the Indenture as “amount” looks to me to be defined (page 14 of the Indenture) as principal amount.

More recently, Windstream has argued that the $40 million may be an equal “amount” because the fair values are similar or a premium or a bit of both, but regardless it was allowed. While Windstream lawyers have done a terrible job, the Judge should be able to see through that the $40 million of additional debt is allowed as Permitted Refinancing Indebtedness under the indenture as reasonable and necessary premium (premium meaning a  payment in excess of the principal amount). And that premium was reasonable because, economically, that premium compensated Noteholders for the reduced interest they would receive in the August 2023 Notes and the additional risk they were assuming by extending repayment in a troubled company. The refinancing and premium were necessary because unless Windstream reconstituted the pool of August 2023 Notes, Aurelius, for its own singular benefit, would have used the rights created to protect bondholders to harm the company, its employees, its stakeholders and harm other bondholders whom the Indenture was designed to protect.

The problem lies, as Aurelius points out, that Windstream has said in the past (repeatedly) that little to no premium was paid, and only recently has changed their argument from the additional debt was permissible under “amount” to the additional debt was permissible as “amount” or “premium”.   So, per Aurelius, Windstream’s claim now that the $40 million is premium should not be allowed. I think Windstream was outlawyered and caught up on some other meaning of premium that might have implied they treated exchanging bondholders better than they treated the original August 2023 bond holders.  All that said, it should be clear to the Judge that the additional debt is premium. It just was premium paid in additional notes as opposed to cash. I feel strongly the facts outweigh bad lawyering, and the Judge will view the process Windstream and Citibank undertook to design and execute the exchange to be reasonable and necessary.

Catalyst

Win baby win. The Company needs to prevail at trial. Aurelius has done much of the dirty work here and facilitated a massive extension of maturities (albeit at high frictional litigation and business disruption expense). The lengthening of maturities has given the Company more runway as there are no near-term catalysts for default (other than the litigation and/or a massive worsening of operating performance). Should the Company lose and not be able to stay the decision, a lengthy and messy bankruptcy is likely to occur as creditors fight over these various transactions and try to claw back money from Uniti stake holders. Current trading levels and yields would appear to account for a fair amount of that risk, but the bonds would probably trade down further should the Company elect to file to protect stakeholders from Aurelius' games. We believe that the Company has many path's to victory and that an Aurelius victory is a low probability event (10-20%), but with one judge in control nothing is ever 100% (see the recent Amex litigation for Exhibit A on legal risk).