By Jason Born, CFA
We find the inspiration for our title in today's piece from the wildly popular series of books by J.R.R. Tolkien which together formed The Lord of the Rings. While the second book actually refers to several towers and so there is some disagreement among adoring fans to which of them Tolkien's title makes reference, the successful movie franchise manned by Peter Jackson makes a bold choice and removes the confusion. The first tower is called Barad-dur and is home to the evil eye of Sauron. The second tower in the film is called Orthanc, home to Saruman who is "less bad" than Sauron, but evil nonetheless.
In our review of two communication tower owners, SBA Communications Corp (SBAC) plays Barad-dur while American Tower (AMT) stars as Orthanc. Now before your imagination runs rampant, let us dispel any notions you have that we are calling these organizations "evil." To the contrary, by all accounts they provide wonderful services to their customers and have proven to be exceptional capital appreciation vehicles for their stock owners. It is in the case of their valuations that we lay the "evil" (a.k.a. overvalued) claim. And just as Barad-dur is the more evil of the two Tolkien towers, SBAC is the more overvalued of the two companies.
AMT is the larger of the two boasting a market capitalization of over $28 billion. It owns about 50,000 communication sites and generates revenue by leasing antenna space to multiple tenants on each site. Most of its properties are located in the U.S., India, Mexico, and Brazil but they also own sites in countries as far-flung as Chile, Ghana, Uganda, and Peru. As should be expected tower leasing companies, in general, have a high degree of customer concentration. American Tower is no different in that four tenants account for 74% of its U.S.-derived revenues while five tenants make up 54% of AMT's international sales. Its largest customers in the U.S. include: AT&T (T), Sprint Nextel (S), Verizon Wireless (VZ), and T-Mobile (OTCPK:DTEGF). The largest international tenants for AMT are Iusacell in Mexico, Nextel International, Telefonica (TEF), MTN Group Ltd. (OTCPK:MTNOF), and Vodafone (VOD). Beginning on January 1, 2012 AMT restructured itself as a REIT and therefore, began paying its first dividends this year.
SBAC owns about 13,000 communication sites and carries a market capitalization of just over $7 billion. Like AMT, SBAC does most of its business in the U.S. with AT&T, Sprint Nextel, Verizon Wireless, and T-Mobile. SBAC has some international business in the likes of Canada, Costa Rica, El Salvador, Panama, Guatemala, and Nicaragua. SBAC is not a REIT, but many analysts and financial writers have speculated that it is only a matter of time before they make the transition. SBAC certainly likes such talk as it takes focus away from its string of net losses as investors hope and pray that some other income data point is a more accurate reflection of its operating performance. SBAC currently pays no dividend.
In nearly every metric that carries any meaning at all AMT is superior to SBAC. Both carry ample debt, but from recent quarterly filings we find that AMT has a debt-to-capital of 69% while the same ratio for SBA Communications is 89%. Interest coverage for AMT runs at 2.6 times, but for SBAC interest coverage is only 0.4 times (yes, that means that EBIT is only 40% of the SBAC's interest expense). Please note that on frequent occasions SBAC management issues new shares to the public, bringing in needed equity capital. That may be acceptable if debt was brought into a more manageable range or if a dividend was declared. However, neither of those events seems to occur. Also recall that one of the reasons a firm issues equity would be that management perceives the stock price to be fairly or even overvalued.
Revenue growth for the past several years for SBAC has been solid at about 12% yet it trails the 14% growth for AMT. On an operating basis, the measure that highlights either management skill or a strong market niche, AMT trounces SBAC. American Tower consistently posts operating margins in the 35% range while SBAC seems to struggle to produce 10% operating margins. Free cash flow measures are also superior at AMT versus SBAC.
So since AMT proves to be the clear winner with regard to size, capital allocation, and operational efficiency, an investor should expect its shares to trade at a premium to SBAC. Let's compare.
First to make certain that we compare apples-to-apples, we will convert the net income figure from SBAC's statements to Funds From Operations (FFO). As a baby nestling to his mother, those of you familiar with REITs will find comfort in our use of FFO. We estimate that the 2012 FFO for SBAC will fall between $1.32 and $1.65 per share. Then, to be very accommodating to the fans and shareholders of SBAC (note: we actually recommend conservative estimates) we will just go with our highest estimate of $1.65. We'll do the math on this FFO figure, but encourage you to see what the results look like at the low end. At a recent price of $60 per share, the stock trades at 36 times 2012 estimated FFO. To see if that is reasonable we project another year of 11% growth and then 5% revenue growth forever. A discount rate of 12% because of the company's high leverage gives us a fair value of $26/share. Lowering the discount rate for who-knows-what reason to 9% makes the fair value $46/share. So in our rosiest-of-rosy forecasts SBAC is 30% overvalued. But it might be as much as 130% overvalued.
AMT may produce an FFO number for 2012 close to $3 per unit. AMT's recent price was $71 per unit which tells us that it trades at about 24 times FFO. Assuming growth of 13% in 2013 and then 5% thereafter discounted at 11% (not as high due as SBAC due to lower leverage) gives us a low fair value per unit of $57. Discounting at 9% yields an intrinsic value for AMT units of $85.
The upshot is that AMT appears to trade in the middle of its fair value range at a multiple of 24 times 2012 FFO. Since the company clearly appears to be superior in almost every way to SBAC, it should trade at a premium. Yet, SBAC trades at 36 times 2012 FFO and is well over its intrinsic value no matter how fancifully we measure.
The verdict - hold AMT (that is, search for better opportunities for it offers no particular bargain) and sell (short, if you can stomach the unvarnished risk) SBAC. Following this advice should allow you to avoid the potential harm these two towers could cause to your portfolio.