Summary
- Spin-offs, as a group, offer market-beating returns.
- Communications Sales & Leasing, Inc is an attractive REIT spin-off - the first of its kind.
- It trades for less than 10x FFO and has a well-covered dividend yield in excess of 8%.
Introduction
Numerous research studies show that spin-off stocks outperform not only their industry peers, but the overall market as well. Therefore, I believe that looking for investment opportunities within the spin-off universe may provide market-beating returns. If one is able to cherry-pick (correctly) among spin-offs, returns could be higher yet. If one is able to meet secondary goals (i.e. income generation), that's icing on the cake.
Investment Opportunity
Communications Sales & Leasing, Inc. (NASDAQ:CSAL) is a spin-off from Windstream Holdings, Inc. (NASDAQ:WIN). CSAL is a REIT that owns communications distribution systems, mainly fiber optic and copper cable systems in multiple states. Overall, the assets include 65,600 miles of fiber and 235,300 miles of copper assets, the total being 300,900 miles. Other assets include central office buildings and telephone poles.
Capital Structure And Valuation
Immediately following the spin-off, CSAL expects to have approximately 150,366,000 shares of common stock outstanding on a fully diluted basis, which at the present share price of $28.60 represents the market cap of about $4.3B. In the SEC form 10, the company details FFO of $451.5M and FAD (funds available for distribution) of $458.7M. This means CSAL is now trading at less than 10x FFO or FAD. This is inexpensive by any measure. Even at a still-inexpensive 14 times FAD, CSAL would have a $6.42B market cap, representing nearly 50% upside.
Of note, CSAL will also carry $3.65B in debt - debt to market cap is, therefore, less than 50%, which is reasonable for a REIT. Leverage can create upside - leveraged stocks tend to move higher with a given earnings increase than non-leveraged stocks. Leverage can also mean risk, as leveraged stocks tend to move lower with a given earnings decrease than non-leveraged stocks. However, I believe the risk is worth bearing in this case. Please see below for additional comments.
Dividend
The company intends to pay out a $2.40 per share annual dividend, for the current yield of about 8.4%. This is a higher yield than that of most U.S. REITs now. The dividend/FFO payout ratio, per information found in SEC Form 10, is ~86.6%. The dividend appears secure.
Earnings And Growth
Initially, CSAL will earn essentially all of its rent from Windstream, to which it is leasing back the distribution systems it acquired in the spin-off. Such heavy reliance on a single customer creates a risk. All leasing will is done on triple-net basis, which means that Windstream is responsible for taxes, insurance and maintenance in addition to rent. The initial lease term is for 15 years, which limits the downside risk somewhat. At the option of Windstream Holdings, the master lease may be extended for up to four five-year renewal terms beyond the initial 15-year term. Given that the distribution assets are critical to Windstream's function, I expect that CSAL's rent is reasonably secure.
The financial condition of Windstream will also improve after the spin-off, making it a more creditworthy tenant. From SEC form 10:
$2.35 billion in principal amount of notes will be issued to Windstream Holdings' wholly owned subsidiary, Windstream Subsidiary, as partial consideration for the contribution of the Distribution Systems and the Consumer CLEC Business assets to us by Windstream Subsidiary... We expect that Windstream Subsidiary will exchange these notes for outstanding debt of Windstream Subsidiary... We expect that approximately $1.1 billion in cash from the proceeds of CS&L's long-term borrowings will be transferred to Windstream Subsidiary, together with CS&L common stock and CS&L debt securities, in connection with the contribution of the Distribution Systems and the Consumer CLEC Business assets to us by Windstream Subsidiary, and will be used to retire Windstream Subsidiary debt.
CSAL also wants to be acquisitive, having mentioned interest in wireless towers and data center assets in the SEC form 10. As acquisitions occur, the company will diversify away its dependence on the single customer (Windstream) and if acquisitions are accretive, grow FFO and FAD. Accretive, diversifying acquisitions should further lower the risk, as they happen.
The Company also intends to support its tenant operators by providing capital to them for a variety of purposes, including capacity augmentation projects and network expansions. They expect to structure these investments as either lease amendments that produce additional rents or as loans that are repaid by operators during the applicable lease term.
Executive Incentives
In my opinion, the CEO, Mr. Kenneth Gunderman, is well incentivized to align his interests with CSAL shareholders. From SEC form 10:
Subject to and conditioned upon his continued employment through the Spin-Off, CS&L will grant Mr. Gunderman a time-based restricted stock award with a grant date value of $2,625,000, which will vest in full on the third anniversary of the Spin-Off. Additionally, for the fiscal year in which the Spin-Off occurs, CS&L will grant Mr. Gunderman restricted stock with a grant date value of $2,625,000; no more than seventy-five percent (75%) of the grant will be comprised of performance-based restricted stock or restricted stock units and the remaining percentage will be comprised of time-based restricted stock or restricted stock units vesting ratably over the three year period following the Spin-Off.
Given that Mr. Gunderman's starting salary is "only" $700,000 per year with a target bonus equal to 150% of his base salary, a very large portion of his compensation is stock-based, likely mostly performance-based or restricted stock.
Does Spin-Off Mean Payoff?
In my opinion - probably, for the following reasons:
- As a focused, pure-play REIT, CSAL is more likely to be acquired.
- CSAL could issue equity on more favorable terms, than would be possible absent spin-off, to make accretive acquisitions.
- CSAL's long-life, critical income-generating assets are more likely to be recognized by the market when they stand alone, instead of being tucked away within a communications company.
- CSAL will now be able to approach Windstream's competitors to buy assets from them and lease it back to them; again, this would not be possible without spin-off.
- CSAL expects to be the only REIT focused on owning and developing communication distribution systems across the United States. This is a competitive advantage, because CSAL may, for a while, be the only REIT to participate in the following opportunity:
- CSAL believes, per form 10, that there is a large (emphasis mine) market opportunity to provide capital to communication service providers to build new and enhance existing communication distribution systems across the United States. CSAL also believes that a number of communication service providers would like to de-lever or are seeking liquidity while still wanting to continue to operate their existing businesses. CSAL also believes that a number of communication service providers would be willing to enter into transactions designed to monetize their network assets (i.e., fiber and copper distribution systems) through sale-leaseback transactions with an unrelated party not perceived to be a competitor, such as CSAL. These communication service providers could use the proceeds from the sale of their communications infrastructure assets to repay debt and rebalance their capital structures, while maintaining the use of the sold network assets through long term leases. CSAL also hopes to provide such communication service providers with expansion opportunities that providers may not otherwise be in a position to pursue by providing them with capital to expand and enhance their network assets at more attractive rates than they may be able to receive through traditional debt financing arrangements. As such, CSAL believes there are numerous opportunities for it to evaluate and potentially pursue following the spin-off.
Conclusion
I believe CSAL, as an inexpensive spin-off with a first mover advantage, possesses significant upside and limited downside risk. During the time it takes for the market to recognize the value of CSAL, investors can expect to be handsomely paid in the form of dividends.
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