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By Michael Hodel, CFA | 08-17-2015 03:00 PM

A Fantastic Business Model in Telecom

Wireless-tower companies such as Crown Castle, American Tower, and SBA have dug themselves economic moats through high customer switching costs, but carrier consolidation is a risk.

Michael Hodel: The wireless-tower industry presents investors with the opportunity to buy into a fantastic business model. Wireless towers, the structures that you see around your neighborhood, hold the equipment that wireless carriers used to provide service to their customers.

What makes the business model so great is that wireless carriers typically sign very long-term contracts with wireless-tower owners--typically 10 years or more. Those contracts call for annual rent increases that drive nice, steady cash flow for the wireless-tower companies.

In addition, wireless carriers face very high switching costs if they want to move equipment from a tower to another location. They would incur costs in doing so and also risk angering customers if service level is changed. Among the wireless-tower companies that we cover at Morningstar--American Tower (AMT), Crown Castle (CCI), and SBA (SBAC)--we award all three of those companies a narrow economic moat on the basis of those switching costs.

The wireless-tower business isn't without its risks, though. The biggest risk facing investors is carrier consolidation. In the recent past, we've seen small-scale consolidation with companies like MetroPCS and Leap being acquired by larger companies; but in the future, you could see a larger deal--most likely the merger of T-Mobile (TMUS) and Sprint (S). While a Sprint/T-Mobile deal is off the table today for regulatory reasons, that could change after the 2016 election. A merger between those two firms would likely dramatically reduce demand for wireless-tower space over the long run.

In addition, we expect the wireless-tower companies to be sensitive to rising interest rates. The tower companies themselves hold significant leverage, and refinancing that debt over time could pressure free cash flow. In addition to that, we expect that investors will likely require higher returns for holding wireless-tower stocks in the future, which would pressure the multiples that the stocks trade at.

Our favorite among the wireless-tower companies today is Crown Castle. We think it's the most undervalued on a fundamental cash flow basis, and the firm also pays out the highest dividend of any stock in the sector.

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