By Imari Love
For years, American Tower (AMT) has been the best of the publicly traded tower companies because of its superior asset base, strong economic efficiency, international diversification, and low leverage relative to peers Crown Castle International (CCI) and SBA Communications (SBAC). As this wireless and broadcast communications tower firm approaches its conversion to a real estate investment trust, the investment community will begin to look at it through a slightly different lens. But even though its peer group might be changing, from an investment perspective we think American Tower remains at the head of its class.
In the tower sector, American Tower offers the best combination of growth and economic efficiency. It has the best margins in the group and industry-leading cash flow growth. Geography, sourcing, and tenancy are all critical factors in gauging the quality of a tower portfolio. Location is important, but population density is not the only factor. Capacity, ground space restrictions, and revenue sharing can be equally important when determining portfolio quality. When taking these other factors into account, a tower outside a top 100 market could easily generate more income than one in a major center like New York or Los Angeles.
American Tower has the best tower portfolio quality because virtually all of its domestic sites came from tower companies and legacy wireless carriers, which tend to have fewer revenue-sharing deals with landowners, better ground lease situations, and more capacity. AT&T (T) and Verizon (VZ) already had spectrum before the personal communications service spectrum auctions in 1995, and thus had the time for a measured, methodical tower buildout with long-term considerations and multiple tenants in mind. The newer carriers had to roll out more quickly and tended to build more for their own use, which justified towers with less capacity and weaker ground lease dynamics. When Crown Castle acquired tower operator Global Signal in 2007, its portfolio was diluted with 8,000 towers built by newer carriers and paging companies. That year, its gross margin fell more than 2 percentage points and its operating margin was cut by more than half.
During the past three years, American Tower has surged past Crown Castle in terms of tower expansion; it now owns more towers than the two other operators combined. Nearly 90% of its tower growth in this time has come on the international side, which now represents 44% of the firm's overall portfolio. American Tower's international growth has allowed Crown Castle and SBA to close the gross margin gap a bit because international margins are roughly 13 percentage points lower than domestic margins.
Despite this, American Tower is still the sector's gross margin leader thanks to better tower sourcing and the fact that it has the least revenue exposure to lower-margin site development (only 2% versus 9% and 12% at Crown and SBA, respectively). This, along with its international exposure, has helped American Tower generate the highest returns on invested capital in the sector. Although international gross margins are lower, returns on invested capital are actually higher because of better pass-through of expenses and lower building costs. The REIT conversion will expand American Tower's lead in this metric because of its nonexistent corporate tax bill (for the REIT portion of its business).
American Tower is also cheapest on an enterprise value/tower basis, despite the fact that it's larger, more efficient, and has lower leverage. Crown and SBA will increase cash flow faster during the next few years, but from a much smaller base. While American Tower expects 40,000 sites by the end of the year, we think it has close to 45,000 in its grasp, given its recent moves in South Africa, Ghana, and Colombia. Its asset base's size, quality, and efficiency have allowed American Tower to form the sector's lone economic moat.
Stacking Up Against Its New Peers
American Tower's investment profile relative to its new REIT peers is even more impressive. The firm is converting to a real estate investment trust because this is the optimal cash distribution and tax strategy, given the economics of its business. The structure allows shareholders to avoid being taxed at both the investor and corporate levels.
After the conversion goes through at the turn of the year, American Tower will be one of the biggest REITs in the country. Roughly 98% of its income is generated from income-producing real estate, and virtually all of its customers are investment-grade. Its profile should be attractive to income investors looking for attractive underlying growth to support shareholder returns.
American Tower rates well against its REIT peers in terms of price/funds from operations, growth, and leverage. FFO is the most commonly used metric to gauge cash flow from REIT operations. To calculate FFO for American Tower, we took 85% of the depreciation and amortization expense, because that is what we can attribute to real estate. American Tower is slightly cheaper than the sector average and also growing faster. Better yet, it has less leverage than most of the sector. This, combined with robust, visible cash flow growth, makes American Tower one of the most balanced investments on the grid.
We believe a REIT's economic moat comes from imposing steady rent increases on tenants in supply-constrained markets. These rent increases need to be in excess of the rate of inflation; otherwise, investor returns are not keeping pace with the debasement of the dollar. For American Tower, the annual price escalators embedded into its contracts are usually 3%-4%, slightly higher than the average U.S. inflation rate during the past century. Outside the United States, the vast majority of the leases are tied to the CPI of that country (plus a small sweetener). Zoning restrictions protect the industry from ever generating a supply glut.
For property landlords that depend on short-term leases, geographic location and property quality are the main determinants of a moat. In contrast, for property landlords such as American Tower that engage in longer-dated tenant leases, a well-underwritten lease with contractual rent increases or profit-sharing agreements is more important. In our opinion, these sources of long-term rent growth--location and lease terms--are examples of the network effect and high switching costs, respectively. One of the reasons American Tower is the only tower firm to which we've assigned a narrow moat is that management has been able to consistently generate sector-leading gross margins.
Growth Prospects Remain Intact
The conversion to a REIT structure shouldn't compromise American Tower's growth prospects in any way. Between the cash on the balance sheet and the free cash flow it will generate on a yearly basis, the company should have no problem funding further expansion.
American Tower has always had a very disciplined and well-defined methodology for capital allocation. Its funding responsibilities, in order of priority, have been capital expenditures for existing towers, acquisitions, and share buybacks. Starting in 2012, the mandatory REIT dividend will take top priority, but the rest of the list will remain the same.
After speaking with the firm, we are confident it will continue to buy back shares, albeit at a slower pace. Even after paying out a dividend and repurchasing shares, the firm will have the resources to fund more than $1 billion in annual acquisitions. Years from now, we expect depreciation to decline, but we don't project an extreme jump in dividends/taxable income, as management intends to increase the dividend steadily each year. Also, the firm still has net operating losses it will be able to use in the coming years to shield taxable income.
Our fair value estimate for American Tower is $66 per share, which equates to a price/funds from operations multiple of 17.5 times for 2012. Just as Global Signal did before it was bought out four years ago, we believe American Tower will trade at a premium to the REIT sector, given its emerging-market growth prospects, cash flow visibility, and lower leverage.
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