Crown Castle International (NYSE:CCI) operates wireless towers primarily in the US. Like most of its competitors, CCI has been growing slowly but unprofitably for a long time and is expected to remain so through 2010. It is highly levered and could easily experience a cash crunch within the next two years. Nevertheless, it is trading at a bewildering 92x consensus earnings estimates for 2011 (not 2010). In recent M&A deals, per-tower prices imply a valuation for CCI that is about 35% lower. Management and insiders have taken advantage of this to sell 30% of their shares over the past 6 months.
The bull case
The wireless tower industry looks attractive on the surface:
o Revenues are recurring, predictable and growing slowly. Over >90% of CCI’s sales are from renewals.
o Leases with tenants are typically long-term. The average CCI tower lease has 7 years to go.
o Towers can accommodate multiple tenants (wireless carriers), but maintenance costs per tower are largely fixed, so revenue from additional tenants is very profitable. In CCI’s case, substantially all towers can accommodate at least one more tenant.
o Additionally, there seems to be plenty of room for growth as 3G and 4G networks come online, and as users switch from just talking on cell phones to using them in data networks. US Wireless data service revenues for the first half of 2009 increased by 31% over the first half of 2008 and now represent approximately 28% of the total average revenue per user.
As a company, CCI looks like it’s about to turn the corner:
o It has just reported a profitable quarter, earning 5c/share in Q4 2009. Q1 2009 was also barely profitable.
o It has about 1.8B in NOLs, and is not expecting to pay taxes for 7 years.
o It grew revenue per tower approximately 10% in 2009, primarily from increased tenant density (per tower)
So, what’s wrong with this picture?
Wireless carriers used to own and operate their own towers, and some of them still do. However, the industry evolved into a model of 3rd party operators primarily because one tower can usually accommodate five or more carriers, and it is more efficient to share. Additionally, this business model reduced capex requirements on the carriers and created revenue stability for tower operators, so they could be valued more highly.
The valuation part of the thesis worked out beautifully: The top three largest publicly traded tower operators in the US (AMT, CCI and SBAC) trade at over 5x book and 8x revenue. Unfortunately, the operational reality is a little less sunny: Of the three, only AMT is profitable, and only since 2006. SBAC has been unprofitable each year since 1999. CCI has been unprofitable each year except 2004. Not a good record.
The tower industry is suffering from three adverse trends that are not likely to stop anytime soon:
1) Wireless carrier consolidation: Wireless carriers have been merging and consolidating so quickly it’s triggered a recent and well-publicized FCC inquiry. Carrier consolidation hurts tower operators in two ways: The number of tenants per tower goes down, and the surviving carrier’s negotiating leverage goes up. In fact, lower network costs and economies of scale are one of the major rationales for the mergers. These economies are extracted directly from the tower operator’s bottom line.
2) Tower technology advances: Early cell towers were very tall and their locations were chosen to support as many subscribers as possible per tower. As a result, some towers were in “prime” locations and could command high rents. More recently, the technology has evolved from “best location” to “multiple location.” Newer towers are more numerous and lower to the ground, and coverage is much more of a patchwork. This improves coverage redundancy and reliability, but it means there’s almost no such thing as a “prime” spot any more. That’s good for wireless customers like you and me, good for wireless carriers, bad for tower operators and owners. We can see evidence of this trend in dropping cell tower lease rates. This trend is slow because leases are usually long term, but it should intensify as the technology evolves to make coverage cheaper to deliver.
3) Dropping barriers to entry and switching costs: Contrary to CCI’s 10k, it is cheap and getting cheaper for a cell phone carrier to switch towers. It has also gotten cheaper to put up a new antenna, particularly in urban locations where they can go right on top of an existing roof or water tower. New “stealth” towers are much less of an eyesore, and are becoming easier to get through local ordinances and building standards (although they are a bit more expensive to build). These advances work toward increasing competitive intensity among tower operators. It is reminiscent of the shift from mainframes to PCs.
Additionally, the U.S. wireless market is pretty close to being fully penetrated at 91%. Sure, there is some growth remaining – a few countries like Finland and the U.K. report wireless penetration rates as high as 120% (100 people have 120 phones). However, these countries are much smaller geographically than the US and have higher population densities. Even if we accept 120% as a target, surely we are past the fast-growth part of the curve and well into the diminishing returns area.
There is also some growth in minutes (3% YoY) and data (31% YoY) but that kind of growth accrues primarily to the wireless carrier because tower lease rates are generally fixed, and do not depend on the volume of traffic the tower handles. There is some room for renegotiation when leases are up, but that is infrequent and due to increased competition between tower operators (as discussed above) lease rates end up going primarily down, not up.
The tower industry is also particularly prone to inflation risk, which has not been mentioned much. This is because – like many commercial property owners – its revenues are fixed and long term (average CCI lease expires in 7 years) whereas costs (maintenance) are short term and primarily driven by inflation. So if you believe inflation is going to tick up over the next 7 years, this opportunity should of interest.
At the end of the day, there is just very little differentiation between a CCI, AMT or SBAC tower. There are no major economies of scale that I can discern – AMT, the only profitable competitor – has slightly fewer towers than CCI. Lease rates for the towers are driven much more by location than by the “brand” of the tower, which means that economic profits accrue (or will eventually accrue) to the owner of the underlying real estate, not necessarily to the operator. CCI owns the land under just 24% of the towers it operates
Problems with the company
CCI is covered by a small army of 16 sell-side analysts. Additionally, the company provides quarterly guidance on revenues, net income, EBITDA, etc. And, isn’t the point of investing in wireless towers that the revenue is so predictable? So, I would not presume to second-guess this highly compensated and trained group by attempting to craft a more accurate forecast. I would, however, question the valuation:
The analyst consensus is that CCI will lose 6c/share in 2010 and earn 42c/share in 2011. Let’s say that’s exactly what will happen. At the current price, this comes to about 92x projected 2011 earnings. That’s pretty high on an absolute level. What’s interesting is that is even high relative to CCI’s top competitor, AMT, which is also overpriced in my opinion. AMT trades at “only” 65x TTM earnings and 51x 2010 earnings, despite the fact that AMT has the better reputation, higher revenue per tower, lower leverage and actual profits. I guess Mr. Market would rather pay up for prospective growth than ongoing profits.
CCI’s market cap is about $11B, and it operates 24k towers, implying a value of about $457k per tower. AMT bought 88 U.S. towers in Jan-Sep 2009 for an average of $292k/tower, 65% of CCI’s value. This is probably the most comparable deal. AMT bought several other towers in 2009 for $58k and $223k per tower, respectively 13% and 49% of the CCI-implied value, but these were located in India and Brazil which are less mature markets (though higher growth) and probably deserve a lower valuation.
About the only M&A deal I could find that could possibly justify CCI’s valuation was when CCI bought Global Signal (NYSE:GSL) in January 2007. CCI paid about $5.8B for GSL’s portfolio of 10,659 towers which comes to $544k per tower or 120% of CCI’s current value. The rationale for the deal was that GSL’s portfolio was complementary, and its towers were “less mature” i.e. had fewer tenants per tower, so if CCI could increase that to match its own tenants per tower, it would realize synergies. In the two years since the acquisition, CCI has been able to boost tenants per tower from 2.5 to 2.9. However, given the massive price it paid, I believe the benefits accrued mostly to the selling GSL shareholders. I think it overpaid in the 2007 market peak.
CCI boasts $1.8B in NOLs, and pays very little taxes. What’s interesting is that management claims it will exhaust its NOLs in seven years. That seemed like a very long time to me, considering the valuation. I tried to think through what that management forecast looks like. For simplicity’s sake, let’s assume CCI will grow NI 10%/year for 7 years (which will be hard to do , that total NI over the 7 years will be 1.8B, that it will be able to convert all NI to FCF (an aggressive assumption that is also incompatible with the growth assumption above), at that the end of that period, CCI will keep on growing at 3% a year forever (= inflation). I tried to do a couple of “back of the envelope” DCF-type valuations using these #s and all manner of discount and growth rates, and I can’t seem to get above 30% of the current CCI market cap. I must be missing something big.
Adjusted EBITDA / FCF
CCI curiously states that “Adjusted EBITDA…is the primary measure of profit and loss used by management for purposes of making decisions about allocating resources to, and assessing the performance of, our operating segments.” I thought this was a bit strange – shouldn’t management be looking primarily at net income? Return on capital? Or at least EBIT? Perhaps this is why the company (and industry) is chronically and unabashedly unprofitable.
Nonetheless, I tried to value the company using free cash flow (which I assume is what “adjusted EBITDA” is trying to capture). Using FCF=Operating CF-Capex, we get $398m of FCF in 2009. The enterprise value is about $17.5B so we have a paltry FCF/EV yield of 2.3%.
Suppose we want to refine this calculation to only use “maintenance” capex. Management claims only $28m of the $173m in capex was “sustaining” and the rest was “discretionary.” I think this is highly suspect, because management also states that “During 2009, we limited our discretionary investments, including a reduction in discretionary capital expenditures, in order to increase liquidity available to retire debt and settle certain of our interest rate swaps.” I believe this means they cut discretionary spending to zero to save cash. Also, of the 3 public competitors profiled above, the lowest capex/sales I could find in any of the past 3 years was around 11%, which is about what CCI spent in 2009, so I think that is the right “maintenance” capex figure. But even if we take management at their word, FCF goes up to $543m, and the FCF/EV yield only goes up to about 3.1%.
Insiders sold 6.5m shares over the past year, including 4.6m shares over the past 3 months. Insiders only hold an additional 13.7m shares, so these sales were very significant relative to holdings. There were no insider share purchases over the past 12 months.
So far, I’ve presented a couple of different ways to value CCI, and hopefully established that the company is vastly overvalued. But what’s going to bring the valuation back inline, other than a general market correction? I believe the answer is leverage and liquidity.
Given CCI’s nice and predictable cashflows, it has taken on a lot of debt. This was exacerbated by its purchase of GSL in 2007, when it paid a very high price in my opinion. Operating income was insufficient to meet interest expenses in each of the past three years.
If you look at Operating Income / Total Fixed Costs, you get coverage ratios of 0.79, 0.64 and 0.22 in 2009-08-07 respectively. Total Fixed Costs, which are helpfully calculated for us in the 10k, include interest payments, ground lease payments and other things that CCI can’t get out of. They exclude $20m/year that CCI pays in preferred dividends (yes, it has paid a steady dividend despite being steadily unprofitable) because that dividend could be paid in stock instead at CCI’s option.
Another way of looking at this problem is to examine “Contractual Cash Obligations” which the company also tabulates for us by year. These include primarily interest payments and ground least rent which the company will owe. They add up to about $1B/year in each of the next 3 years (2010-12). Compare that with operating cash flow of $571m in 2009 and cash in hand of $766m. Will there be enough cash to cover contractual obligations through 2011? Through 2012? What about the ambitious expansion plan, and dividend payment? If not, where will the extra cash come from? Are there any answers that could be good for equity holders?
CCI has already refinanced $5.2B of its 6.5B in debt in 2009 to extend maturities into future years. The new debt bears higher interest rates on average, with senior unsecured debt yielding 9%. This will make things harder for the company moving forward. The bond market seems to be waking up to the risk the company poses.
If you agree with the analysis of CCI but disagree with the analysis of the tower industry, or if you just want less delta exposure, you can still take advantage of the mispricing by going short CCI and long AMT. As mentioned above, AMT trades at “only” 65x TTM earnings and 51x 2010 earnings, compared to CCI’s 92x 2011 earnings, despite the fact that AMT has the better reputation, higher revenue per tower, lower leverage and actual profits.
Disclosure: Short CCI