By Imari Love
The near-term momentum in the wireless tower industry is undeniable, and we believe there is still meaningful upside for American Tower (AMT), Crown Castle International (CCI), and SBA Communications (SBAC), given how economically compelling the sector's fundamentals are. Over the past six months, the industry has seen an unprecedented level of leasing activity from the four major U.S. carriers that are actively engaged in 4G LTE network deployments. When we consider the consistency and reliability of the industry's cash flow generation, expansion overseas, and the improving economic efficiency of the operating models, we believe these firms will outperform the market for the foreseeable future.
We define economic moats as sustainable competitive advantages that allow firms to generate positive economic profits for an extended period. The underlying sources of economic moats are switching costs, intangible assets, network effect, and efficient scale. While American Tower remains our top pick, we believe the entire sector will continue to outperform the market in 2013.
Switching costs ensure low churn rates. There are considerable switching costs in the industry. It would cost a carrier roughly 20 times its monthly rent to take its equipment off a tower and move it to a neighboring tower. It is not an economically viable decision to pay $40,000 in an attempt to save $200 per month at a competing tower operator.
NIMBY concerns create barriers to entry. Residents may oppose a proposal for new towers being developed near their homes--"not in my backyard." Zoning permits to construct cell towers are becoming increasingly difficult to acquire. It currently takes one to four years to go through the process start to finish.
Economies of scale create massive operating leverage. There are major cost advantages and scale economies in this industry, which produce a tremendous amount of operating leverage. Firms operate with very low amounts of overhead (maintenance capital expenditures are less than 5% of revenue), which makes adding an incremental tenant incredibly profitable.
Shrinking cell site service ring drives need for more equipment/towers. There is now a network effect in the industry. For example, if Verizon has a presence on a tower in a specific area, AT&T will also need to have equipment on that same structure if it wants to be competitive in that area. In most cases, building a new tower nearby is not a viable option. As the competition for smartphone customers (and their high average revenue per user) intensifies, carriers are scrambling to ensure they have adequate network service in every possible region. Having a nationwide presence in every major population pocket has become increasingly difficult, given that the service ring (radius where a cell site can effectively deliver service to mobile devices) is shrinking. The laws of physics are shrinking the service ring in order to get the throughput required. Thus, the smaller service radius increases the need for a denser footprint and more points of presence.
Secular shift abroad should strengthen sector's moat. With virtually all of American Tower's growth coming internationally, SBA expanding into Brazil, and Crown keeping its presence in Australia, there has been a growing concern about whether the sector's economic moat prospects could be compromised through global expansion. Much of that concern stems from the margin differential between American Tower's two segments. Over its past four quarters, American Tower increased its international rental and management revenue more than 37% year over year compared with 12% growth domestically. However, the EBITDA margin on that revenue was 53.2% versus 76.6% domestically. While this seems like a problem area, it's actually an accounting illusion. Internationally, American Tower passes through a significant amount of its land rent expenses to the carrier. There is a corresponding entry made for both revenue and expenses, which drives a zero margin on that specific piece of the revenue and deflates the firm's margin base.
The key tenets of the economic moat are intact when we analyze American Tower's competitive position abroad. The international regulatory landscape in regards to zoning licenses seems to be tightening. Since American Tower has a first-mover advantage in many of these markets, we believe its moat is strengthened even further, especially as these barriers to entry expand. The scale advantages and switching costs are also intact in the international markets. Although labor costs are lower outside the U.S., tenant rental rates are lower as well. Ultimately, the value proposition for tearing equipment off a tower to move it down the road is not favorable.
Crown Castle Leads the Way in U.S. Tower Count
Houston-based Crown Castle International owns, operates, and leases towers domestically and abroad. The firm has roughly 30,000 towers in the U.S. and approximately another 1,700 in Australia. Crown's tower count has been largely stagnant for the past few years but recently received a 30% boost on the back of its 2012 deal with T-Mobile USA for 7,100. That deal solidifies Crown Castle as the largest wireless infrastructure provider in the U.S. and strengthens its presence in the top traffic areas around the country. Roughly 83% of the T-Mobile sites that are being acquired are located in the top 100 markets. The new towers also only have an average of 1.6 tenants per tower (including T-Mobile), which gives the firm plenty of long-term upside for incremental additions. The combination of low existing tenancy, high operating leverage, and minuscule incremental costs should boost the firm's organic revenue and cash flow for years to come.
The T-Mobile deal makes economic sense; the transaction price ($2.4 billion in cash) is only 8% of Crown's enterprise value, yet boosts its tower portfolio 33%. Also, the per tower transaction price came at a discount of roughly 32% to the comparable deals over the past five years (although the firm's net leverage ratio will rise to more than 6 times EBITDA as a result). This wasn't the only move Crown made last year; the firm also closed the acquisition of NextG Networks, the largest independent provider of distributed antenna systems. In the deal, Crown agreed to pay $1 billion for NextG's 7,000 nodes that are on air and the other 1,500 that are under construction. The organic leasing growth in small cells is tracking above expectations as carriers continue to adopt small cells to create a more seamless user experience in areas that don't have sufficient tower coverage.
Crown has seemed to make the decision to invest in small cell infrastructure domestically rather than boosting its tower count abroad--a move we disagree with. Ultimately, the macro tower business (relative to DAS) has better margins, capital efficiency, and barriers to entry. Most of these DAS nodes (which emit radio frequency radiation just like a cell tower but at lower levels) are constructed in urban environments on common infrastructure (for example, light posts or the side of a building) where the firm doesn't own the real estate and thus has less economic control. While Crown is sure to make a decent return on DAS, we prefer the routes American Tower and SBA have taken to boost their international tower presence.
Recent Expansion Into Brazil Hints SBA Is Ready to Take Next Step Forward
SBA Communications, based in Boca Raton, Fla., owns and operates more than 16,500 towers across North, Central, and South America. The firm also manages roughly 5,000 communication site locations on behalf of third-party landlords. On the site development side of its business (roughly 11% of revenue), SBA offers carriers assistance in developing their own networks. Its services include site identification and acquisition as well as obtaining zoning approvals. The firm also provides a broad range of cell site equipment installation, optimization, and integration services. Its site development experience includes participating in developing more than 45,000 communication sites.
At the end of the third quarter, the firm's tower base had increased nearly 60% year over year thanks to its TowerCo acquisition of 3,256 towers in the U.S. and Puerto Rico. While the firm traditionally targets 5%-10% portfolio growth a year (as it has for 2013), we expect SBA to outperform that guidance over the next few years. The move into Brazil was closed in late December and is a positive precursor of things to come. SBA bought 800 free-standing, ground-based towers from Vivo (a subsidiary of Telefonica Brasil) for BRL 362.8 billion ($178 million). The average tenancy is 1.33 per tower (versus just more than 2.0 in the U.S.), leaving plenty of room for long-term upside.
The deal establishes SBA as a major independent tower owner in a country with more than 261 million mobile phones in use (the fourth most in the world). Brazil is going through a massive capital investment phase as it prepares for next year's World Cup and the 2016 Summer Olympics. The government and telecom regulator have been consistently putting heat on the carriers to improve the reach and scope of network coverage, which bodes well for tower firms like SBA and American Tower. While SBA is by far the smallest of the three tower firms and also the most leveraged (net leverage at the end of third quarter was 6.7 times EBITDA), it offers investors the most growth upside potential in the industry.
American Tower Still Biggest and Best
Of the three publicly traded tower firms, Boston-based American Tower boasts the largest and most diverse asset portfolio and the lowest leverage. While the firm has more than 22,000 towers domestically, it now lays claim to more than 30,000 more sites internationally, spanning 10 countries.
Despite doubling the size of its portfolio over the past five years via international expansion, American Tower has held its leverage ratio intact at 3.8 times EBITDA. This is nearly 3 turns better than Crown and SBA and leaves the door open for further needle-moving acquisitions. The other impressive aspect of the global expansion initiative is that it hasn't come at the expense of the firm's return on invested capital. American Tower's ROIC rose from 9% in 2007 to 10.7% last year. The firm converted to a real estate investment trust a year ago and thus is now the only tower firm that pays out a dividend. We expect Crown and SBA to convert to REITs as well, in 2015 and 2018, respectively.
While virtually all of its growth is coming internationally (more than 95% of its new sites in 2012 came outside the U.S.), American Tower continues to solidify its competitive position at home. Recently, the firm signed a new master lease agreement with T-Mobile that extended its average remaining lease term to nine years. This locks in a significant amount of incremental guaranteed revenue, which on a consolidated basis now stands at just under $19 billion. That visibility, coupled with the firm's superior margins and balance sheet, makes American Tower the best of breed in what we consider the most attractive sector in the telecommunications industry.
Mobile Data Growth Lays Groundwork for Sustainable Outperformance
Cisco projects global mobile traffic to increase 18-fold between 2011 and 2016, with mobile network connection speeds rising 9-fold in that same period. Not only will more people access mobile data, but on a per consumer basis, usage will rise as more content is made available online and data speeds make consumption more viable. All of these factors are a backdrop for visible and sustainable capital expenditure spending by the carriers both in the U.S. and abroad. We continue to believe the best way to exploit these trends is by investing in the tower plays: American Tower, Crown Castle, and SBA Communications. Our top pick remains American Tower, given its superior margins, lower debt load, and heightened international exposure.