Crown Castle and the Tower Operators: The Foundation for Next-Gen Wireless

It isn’t exactly a secret that mobile devices such as Apple’s (AAPL) iPhone and Research in Motion’s (RIMM) Blackberry coupled with next-generation wireless services such as 3G and WiMAX are causing a fundamental shift in consumer, enterprise and carrier behavior. Consumption of voice, video and data services over mobile devices is increasing rapidly, and any good investor should be looking for creative ways to take advantage of this.

Unfortunately, the Apple and Research in Motion gravy trains have long since left the station, so investors interested in an alternative should look to the wireless communication tower operators, key beneficiaries who have yet to take off.

These companies own and operate cell towers that are utilized by carriers such as AT&T (T), Verizon (VZ) and MetroPCS (PCS) to enable voice and data services for their customers. Carriers sign long-term contracts to lease space on towers (~80% of revenues) and contract for design, planning and installation consulting (~20% of revenues) to assist with service implementation.

Think of each tower as an apartment building for carriers with about 6 rooms, each renting for $5,000 per month, with leases running 5-10 years, where almost no one moves out. And, the majority of operating costs are fixed (and low), so 75% of each additional dollar in revenue flows directly to EBITDA. Multiply those economics by thousands of towers, and a great business is born.

Public tower operators include American Tower (AMT), SBA Communications (SBAC), and my personal favorite, Crown Castle (CCI), which controls a portfolio of about 24,000 towers in the U.S., Canada and Australia. Crown Castle is best-positioned in this extremely attractive market with a management team deeply concerned about creating shareholder value for long-term oriented investors.

Strong trends in the wireless industry should drive carrier spend

Growth in wireless subscriptions, increasing usage of mobile voice, video and data, and new network builds related to spectrum auctions all contribute to compel carriers to spend money on wireless towers as they seek to increase capacity, capabilities and quality. A typical MetroPCS user on an unlimited voice plan uses 2,000 minutes of voice per month, the highest among all carriers. As other carriers roll out competing all-you-can-eat service plans, introduce new high-end devices and expand geographically, their subscriber base will at least mirror, and more likely surpass, this usage (especially with data plans).

This behavioral phase change will cause networks to be stretched beyond their limit and force carriers to augment their tower footprint with additional sites. Most of this build will be constrained to major population centers, where over 70% of CCI’s towers are located (vs. 60% for AMT and 50% for SBAC), allowing them to benefit disproportionately.

Significant barriers to entry and high switching costs limit competition

Zoning requirements and other regulations create substantial roadblocks for those who seek to build new towers, especially in the denser metropolitan areas where CCI’s are most concentrated. Furthermore, once a tower is built, each incremental tower proposed for a nearby location is much less likely to be approved. And, even if a competitor can get one built, attracting business would prove difficult, as switching towers can cost carriers up to $200,000, making it prohibitively expensive in all but the most extreme situations.

Thus, each tower can act as a de facto monopoly in its region (more than 80% of towers are not located within ½ mile of another). This allows tower operators to achieve substantial pricing leverage and to extract sweeteners such as long-term agreements and inflation escalators.

Favorable operating and cash flow dynamics improve effectiveness and flexibility

Tremendous operating leverage and a small fixed cost base provide extremely attractive EBITDA flow-through margins. To illustrate, in Q208, Crown Castle was able to convert 100% of its growth in site rental revenue into EBITDA –that’s not a typo.

Additionally, low maintenance capital expenditure requirements (only $8-$10m per quarter) and prudent tower builds allow much of EBITDA to convert into free cash. Capital expenditures are typically related to new tower construction, and are only undertaken once an anchor tenant has signed a long-term contract, making the tower viable prior to any truck roll. Additionally, fantastic revenue visibility due to long-term leases and high renewal rates affords unmatched expense planning abilities.

Shareholder-friendly management team understands how to create value

Crown Castle has used its cash wisely, acquiring undervalued, underperforming assets and aggressively buying back shares. The company acquired Global Signal and its 11,000 towers, for $5.6 billion in 2006 to become the largest operator in the U.S. and has made smaller acquisitions at lower multiples, taking advantage of significant economies of scale to drive revenue and cost synergies.

This year, management initially targeted a buyback of $700m, or about 7% of total shares outstanding, though they did not have any activity on this front in the last quarter due to M&A activities. However, on the most recent earnings call, management noted that the share price seemed unreasonably cheap, so expect this trend to reverse quickly.

Continual repurchases and successful capital structure management mean CCI has the fewest shares outstanding per tower site of any publicly traded tower company by between 25% and 50%, meaning that each incremental dollar of cash flow is distributed over fewer shares.

With a debt/EBITDA level well below the target ceiling of 8.0x, and substantial gross margin and EBITDA margin improvements due to operating leverage and acquisition integration, expect buybacks and other shareholder-friendly actions to increase substantially.

An investment in CCI is not without risk

Risks include: slower-than expected growth in wireless subscribers, decreased uptake of high bandwidth services, customer concentration and emergence of new technologies that more efficiently utilize existing towers (or circumvent them altogether).

Valuation

Wall Street consensus EBITDA estimates for 2008 and 2009 are $863.2m and $956.8m, respectively, suggesting EV/EBITDA multiples of 19.4x and 17.5x – pretty rich, indeed, though it should be noted that the stock price has stagnated for two years while recurring cash flow has increased almost 50%. However, these metrics are too short-sighted to do the long-term opportunity justice. A DCF accurately captures the true attractiveness of this highly defensible, capital efficient, “cash cow” business model.

Using a WACC of 7.9%, a risk-free rate of 4.5% and a terminal growth rate of 1% coupled with conservative growth and margin assumptions, I achieve valuations ranging from $63.42 to $73.57, implying upside of between 68.7% and 96.6% from Tuesday’s close price of $37.42.

With limited risk and strong upside potential, Crown Castle would make a strong addition to any value-oriented investor’s portfolio.

Disclosure: none

Comments

[Nanotube:]

The debt/EBITDA of around 8 is also a risk, larger for CCI than for AMT. A credit crunch that lasted two years or so could put them in a bind. Not very probable, but beware of black swans.

2008 Sep 03 11:44 AM

[Nathan Voite:]

There is a huge risk that this article didn't touch on. The cell tower companies and service providers are held liable if somebody is injured or over exposed to RF Radiation. Antennas built on rooftops, mounted on the sides of buildings pose a hazard to third party workers and the general public who may have access to these sites. All a worker has to do to get full life disability is to prove is that he was in an area where he may have been over-exposed (very easily done) and suffers from headaches, mood-swings, or a host of other subjective cognitive maladies. Cell phone companies and tower operators are holding a huge bag of potential litigation. Once the word is out, the law suits will start and earnings will be slashed.

2008 Sep 03 11:48 AM

[Square Circle:]

Thanks for the comments, guys.

Nanotube: I would suggest you take a peek at the current and projected free cash flows, as well as the 10-K to gain more comfort with the capital structure and related covenants. Remember the superior revenue and expense visibility that companies like this have.

Nathan: Any data to support your theory and/or information that would help quantify this risk? CCI is more a REIT than a technology provider, so my guess is this liability would lie much more with equipment manufacturers and service providers than the tower operators.

2008 Sep 03 05:04 PM

[tylakewalker:]

Joe,
Nice article

Nathan,
I think most of the risk would be borne by the company generating the signal (carrier) or the antenna manufacturer not the owner of the steel (tower company) Additionally, I would imagine the lawsuits would generally target the deeper pockets (carriers). Furthermore, radio stations have been generating much more powerful wireless signals for much longer and to my knowledge they have not been successfully sued for damages resulting from RF radiation.

All,
The biggest risk with CCI is the eventual bankruptcy of Sprint Nextel. All of those global signal towers acquired were once upon a time owned by Sprint. So it follows that Sprint antennas will be located on almost all of the former Global Signal towers. When Sprint Nextel goes belly up all of that lease revenue goes away. You can't enforce a lease on a bankrupt lessee.

I have professional experience negotiating and placing antennas on all of the tower companies facilities for all of the carriers and Crown Castle is the best tower company. After I quit working on developing wireless infrastructure I made one investment in wireless telecom and that was a long position in CCI.

2008 Sep 03 10:04 PM

[rox234:]

Why is CCI better than AMT ? It seems that AMT is performing margins and has postive EPS. Thier tower portfolios are pretty comparable, and they too have constistenly met wall street's expectations.

I would assume that both of these companies are very comparable, but looking at the fundamentals its seems that AMT is a bit more profitable.

What is your basis on CCI being a stronger tower company than AMT...other than 10% more towers in metropolitan areas and 2000 more towers, even though they are less profitable ?

2008 Sep 04 11:52 PM

[tylakewalker:]

CCI processes applications quicker than AMT. The carriers want their sites on air as quick as possible. AMT customer service is decent and used to be the best but has slowly gotten worse and fallen behind CCI. When you have a search ring and you can choose between collocating on AMT or CCI I'm going to recommend my client chooses the CCI tower. I don't think AMT is a bad company, I just think CCI is better from a customer service standpoint. They are easier to work with, return calls quicker, more efficient process, etc,. Sometimes you can't get AMT to return a call. CCI has aggressively expanded AND improved their customer service at the same time. I am impressed by that. I admit This is only one aspect of the company but I wanted to add my two cents because of my past experience working with both companies.

2008 Sep 05 09:57 AM

[tylakewalker:]

CCI processes applications quicker than AMT. The carriers want their sites on air as quick as possible. AMT customer service is decent and used to be the best but has slowly gotten worse and fallen behind CCI. When you have a search ring and you can choose between collocating on AMT or CCI I'm going to recommend my client chooses the CCI tower. I don't think AMT is a bad company, I just think CCI is better from a customer service standpoint. They are easier to work with, return calls quicker, more efficient process, etc,. Sometimes you can't get AMT to return a call. CCI has aggressively expanded AND improved their customer service at the same time. I am impressed by that. I admit This is only one aspect of the company but I wanted to add my two cents because of my past experience working with both companies.

2008 Sep 05 09:59 AM

[Square Circle:]

Firstly, I think any of the 3 majors in this sector would make fine investments, I just happen to prefer CCI to AMT.

Here are a few of the main reasons:

1. Lower share base allows for increased participation in earnings, buyback-related accretion, etc.
2. Margin expansion potential for Global Signal towers
3. Superior locations of tower assets
4. Lower risk international strategy

2008 Sep 05 01:09 PM

[Steelintheair:]

While I agree with the fundamental conclusion of this analysis, there are some factual inaccuracies and mistatements within.

1. The average cell tower collocation lease is not $5000/mo- more like $1800/mo. (SBA averaged $1728/mo in 2006) It is very rare for a cell tower collocation (or tenant lease) to exceed $3000/mo.
2. The average tower does not have 6 rad centers (or "rooms" in your analogy) either available or rented. Crown had 2.9 tenants per tower in 2Q 2006. While I have not seen estimates of remaining capacity on existing towers, anecdotally, I would place it between 1.5 and 2 remaining rad centers per tower on average.
3. The statement that 80% of towers are not within 1/2 mile of another tower is somewhat misleading- because it implies that CCI, AMT, and SBA's portfolios are reprentative of this statistics. First, assuming the statistic is correct, it is invariably less accurate in urbanized areas than none urbanized areas. So presumably, the tower companies whose portfolios are in more urbanized areas would have a greater percentage of their towers with competition within 1/2 mile. Furthermore, in urbanized areas there are a greater concentration of other structures which are available for collocation such as rooftops, water towers, and billboards, ect.
4. In suggesting the percentage of towers within urbanized areas, it is important to recognize that the public tower companies break down this statistic by selectively choosing how they define "urban". AMT has suggested that they have 66% in the top 100 Business Trading Areas vs Crown's 72% and SBA's 49%. When you look at the top 50 BTAs, Crown is at 55%, ATC at 47% and SBA at 27%. The point: whatever way you look at it- SBA has significantly less towers in urban areas than either ATC or Crown.

To address some of the comments here:

1. While numerous lawsuits alleging health risks from cell towers and cell phones have been brought- none have been successful with many being dismissed for lack of credible scientific testimony.

2. Without commenting on the risk of Sprint/Nextel going belly up, even if they were to go under, there is significant value in the network assets both in spectrum and cell sites/switches. Secondly, Sprint Nextel would not file Chapter 7, but 11 to reorganize. The cell site leases would inevitably be maintained by the trustee. Furthermore, even after the merger Sprint/Nextel represents 16% of Crown's income vs 21% with AMT and 27% of SBA. (as of 2007 annual reports)

Why do I know this? Because I am regularly retained by the analysts to advise them on these issues. And because my business revolves around knowing what the tower companies are up to. Out of the three of them- I hold CCI shares only.

2008 Sep 08 07:59 AM

[Andrew454:]

All 3 of these companies have traded down lately, and I have unfortunately watched them fall and paid the price. I was trumpeting SBA as a great buying opportunity after AIG, since I thought, on top of the great operating attributes there was also the acquisition possibility, but I have been pretty surprised to see how poorly SBA and CCI in particular have held up in recent weeks. All three of these companies have done a great job of playing the cost of capital arbitrage game in recent years, selling debt cheaply and buying back stock by the boat load, but I am wondering if the reason for the precipitous drop might have to do with the concern that this game is coming to a close? It wasn't too long ago that people looked at all three balance sheets with trepidation at the beginning of the decade, but at the same time, if it made sense to buy back the stock two years ago when it was double the price, it should make even more sense now if they have the liquidity. Do you think investors are pricing in a refi risk on some of the debt in these companies, and, despite the ridiculously high margins, do you think that this is at all justified?

2008 Oct 22 03:16 PM

[Nanotube:]

Until those who used to buy debt and now do not start buying again, all three tower companies will have to change their capitalization. If they are able to delever fast enough, they will do quite well, AMT is in the best position. If it looks like AMT will make it, then CCI and SBAC may use the halo to squeek out also. Since they are down so much they may have better reward/risk ratios.

2008 Oct 30 09:25 PM