SBA Communications Has Great Business Model, But Market Pricing In Too Great A Free Cash Flow Trajectory

Nov.21.13 | About: SBA Communications (SBAC)

SBA Communications (NASDAQ:SBAC) owns and operates wireless communications towers. The company's primary business is leasing antenna space to wireless service providers on towers and other structures. This activity accounts for nearly all the firm's operating profit.

In the US and Canada, tenant leases are for an initial term of 5-10 years with five, 5-year renewal periods at the option of the tenant. The tenant leases have specific tenant rent escalators, which average 3%-4% per year. Before building a new tower, SBA Communications typically has at least one signed tenant lease, so new development risk is generally minimized. Sprint (NYSE:S), AT&T (NYSE:T), T-Mobile (NASDAQ:TMUS), and Verizon Wireless (NYSE:VZ) each account for more than 10% of revenues individually.

The number of towers owned by the company has advanced to over 17,000 from approximately 9,000 at the end of 2010. The majority of its towers are high-capacity towers, where significant capacity is available for additional antennas at low incremental cost. SBA Communications is very well-positioned to capitalize on increased wireless traffic demand and network infrastructure improvements that will translate into more towers and/or more antennas at existing towers.

The attractive characteristics of having scalable tower operations (operating leverage), long-term contracts, built-in escalators, high operating margins, and low customer churn make for a very, very nice business model. However, the company has posted accounting losses in each of the past five years and expects to continue doing so. Why does the market assign such a hefty valuation to this seemingly "money-losing" business?

The answer rests in an understanding of the composition of a company's intrinsic value: the fair value estimate of a company is based on its discounted future enterprise free cash flows, its capital structure (net balance sheet impact), and the number of shares outstanding (the latter is the divisor in the equation). As we outlined here in the example of Amazon (NASDAQ:AMZN), the market is not necessarily focused on assigning a price-to-earnings multiple to a company's earnings-per-share, but instead the market looks at future expected free cash flows of the business and the health of its balance sheet to assign value.

For SBA Communications, free cash flow (cash flow from operating activities less capital expenditures) has been remarkable: +$134 million in 2010, +$122 million in 2011, and +$228 million in 2012. This is a far cry from the net losses over the same period: -$194.7 million (2010), -$126.5 million (2011), and -$181 million (2012). The strong cash-flow performance continued into the company's third-quarter results, released November 4, despite the firm posting a net loss of $36.7 million for the nine months ended September 30, 2013.

Valuentum's Take

The price-to-earnings (NYSE:PE) ratio certainly has its place as a short-cut to valuation analysis when there isn't too large of a disconnect in accounting earnings and economic - cash - earnings. However, the use of the PE ratio isn't as helpful in all cases and brings to light the importance of using a discounted cash-flow process in conjunction with a robust relative value methodology. Firms will always be priced on the present value of their future free cash flows and the health of their balance sheet -- investors may make errors with the assumptions behind these drivers (resulting in the purchase of significantly overvalued stock), but the valuation framework will always be the same in every case.

In the instance of SBA Communications, we're huge fans of the company's business model, but we think the market is pricing in too great a free-cash-flow trajectory in coming years. We believe consensus is capturing the growth cash flows related to future capital investments but only considering maintenance capital expenditures in the free cash flow calculation. This is a significant imbalance in valuation practice and the primary reason why our fair value estimate differs from SBA Communications' stock price.

Also, we believe many are overlooking the firm's massive $5.5 billion net debt position. A leverage ratio of 6.7 times (shown below) not only speaks of significant financial risk (and a higher discount rate), but also counterbalances (to a degree) the future-free-cash-flow component of a company's value make-up (debt reduces the sum of the present value of future free cash flows). We're not rushing to add SBA Communication's shares to our actively-managed portfolios at this time.

Image Source: SBA Communications; 3Q Results Press Release

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.