Global Expansion Key to American Tower's Surging Prospects

Over the past six years,  American Tower Corp (AMT) has transformed from a growing U.S.-based tower firm into a global powerhouse that owns the largest site portfolio of any independent noncarrier in the world. Of the roughly 45,000 towers it has added since 2007, 88% are outside the United States. Given that margins are lower abroad, some investors have been skeptical about the company's long-term profitability prospects. However, while American Tower's margins have declined since 2007, its return on invested capital has actually doubled. With the stock trading at a 9% discount to our $100 fair value estimate, we believe it is fundamentally undervalued.

American Tower Is Becoming Less American Every Day as It Grows Internationally
In its 2007 annual report, American Tower said it had 19,200 towers in the U.S., 2,300 in Mexico, and 700 in Brazil. Since then, the firm has more than tripled its base in Mexico, expanded its Brazilian portfolio nearly tenfold, and entered into 10 additional countries, as shown in the following table. The international rental and management segment now drives one third of the firm's total revenue and one fourth of its operating profit, versus less than 1% (on both metrics) seven years ago.

American Tower's Portfolio Expansion, 2007-14

Source: Company filings, Morningstar Research

American Tower's international exposure has increased to 59% from 14% of total towers since 2007, and we think it can reach two thirds of the base by 2018. Meanwhile, the firm's recurring cash flow and returns on invested capital have taken a meaningful step forward as the tower base has expanded. As American Tower has grown internationally over the past seven years, it is basically building and buying ahead of the inevitable rise in emerging-market demand for mobile bandwidth.

According to mobiThinking, while 3G/4G penetration in the U.S. is over 90%, it is only 39% in Brazil, and in some regions, such as India and parts of Africa, 3G penetration is still in single digits. While all of the major carriers in the U.S. are actively deploying 4G networks, the standard is still in its infancy in many emerging markets. The advanced data network deployment schedules in these regions are still years behind the U.S., leaving a runway for incremental growth through the balance of the decade as a result of site densification and amendment activity needed to facilitate technological migrations.

International Expansion Initiatives Can Fuel Increase in ROICs Over the Long Term
We believe the market is fundamentally undervaluing the economics of American Tower's international operating model. On the surface, international margins and ROICs seem to be lower than in the U.S., and given that international is where the vast majority of the firm's growth has come from, some investors have become concerned with American Tower's prospects. However, we believe the lower margins and returns abroad are an illusion.

ROIC calculations in a given year can be misleading in this business because of the timing of needle-moving acquisitions. For example, in the fourth quarter of 2013, American Tower closed two significant acquisitions with Global Tower Partners ($3.3 billion) and NII Holdings ($811 million). When these deals are consummated, the investment is added to the year-one invested capital figure (ROIC denominator), but the numerator in the equation does not change since the firm doesn't book a full year's worth of revenue from the newly acquired assets. Thus, the firm's consolidated ROIC compresses and in American Tower's case actually declined last year to 10% from approximately 12% in 2012. These issues can be exacerbated by the fact that most of the growth has typically come from less mature, international, single-tenant sites, which are going to be less profitable initially.

We believe that disaggregating returns and normalized cash flow dynamics of the more mature legacy assets from emerging markets paints a much more accurate picture of American Tower's current situation and its prospects. Taking data published in a company investor presentation, legacy assets (sites that have been around since 2007) have shown steady and consistent ROIC expansion. Also, once the assets mature, ROICs abroad can remain higher than they are domestically.

The firm has been able to maintain a high level of profitability because it strictly adheres to its internal rate of return mandates. Given the elevated risk associated with emerging markets, American Tower's management requires its international ventures to clear higher IRR hurdles. These IRR targets have remained steady as the firm's portfolio has grown, which in our view supports the firm's long-term runway for ROIC expansion.

Three Reasons for Potentially Higher ROICs Abroad
There are three key reasons the firm is able to generate higher returns abroad: lower building costs, generous expense pass-through, and higher tenancy growth potential.

Lower building costs. The average cost to construct a tower in the firm's international regions is 50% lower than the cost of construction in the U.S. Based on conversations with management, labor costs constitute roughly 60% of a construction project, and compensation for construction workers in the U.S. can run roughly 15-20 times higher than in a market such as India. While tenant revenue is also lower, the drop-off is not as extreme (on average, single-tenant revenue is 25% lower abroad). That 2:1 ratio of relative decline drives an initially higher gross margin abroad.

Expense pass-through impact. In the majority of its international markets, American Tower is able to pass certain costs (such as ground rent or fuel costs) back to the carrier. The sample tower economic data above is adjusted to exclude the impact of these pass-through expenses, which deflate reported margins. The firm adds back transferred expense to its revenue line and then eliminates this revenue in reported expenses. In the first quarter, American Tower's international segment reported a 61% gross margin. However, when we remove the impact of pass-through expenses on the results, the gross margin is more than 80%. This year, we expect more than $300 million of pass-through expense to be added back to international revenues at zero margin.

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Stronger long-term tenancy prospects. Another key driver of stronger returns is the more attractive lease-up dynamics abroad. While the average rate of tenancy in the U.S. is about 2.7, it's closer to 1.5 internationally. Given our view that emerging markets still have a long way to go in terms of carrier consolidation, the ceiling for incremental tenancy growth is higher on a relative basis. We think American Tower should be able to increase tenancy at a faster pace in emerging markets than it can in the U.S. Over the course of the service life of each tower, an international site can spend more relative time at a higher tenancy rate, which generates elevated cash flow and returns over a multidecade period. Perhaps just as important, the markets are less mature abroad and tend to have lower day-one tenancy rates at the time of acquisition, which could give the appearance of a transaction being very expensive. However, to us, the aforementioned IRR hurdles ensure that any international venture needs to generate elevated returns to offset the incremental risks.

Threat Assessment for American Tower Highlights Reliability of Operating Model

Interest Rate Risk
Given the relatively heavy debt loads in the industry, American Tower and its peers have historically underperformed the stock market in times of rising rates. However, we note that more than 80% of American Tower's debt is locked into a fixed rate, and roughly 80% of the debt doesn't mature until 2018 or beyond. Our valuation model discounts future free cash flows using our weighted average cost of capital. While the cost of debt for American Tower is currently around 4%, in our model we use a more conservative assumption of 4.3%, which projects a small increase in its longer-term costs. A 100-basis-point move in our cost of debt drives an approximately 6% move in our fair value estimate.

Foreign Exchange Volatility
Although the international expansion initiatives have heightened American Tower's exposure to foreign currency headwinds (the vast majority of revenue, tower expenses, and selling, general, and administrative costs are denominated in local currencies), we expect foreign exchange movements to have minimal impact on its operating model. Management has factored bearish currency assumptions into its 2014 guidance, and a 5% fluctuation in foreign-exchange assumptions will drive only a 1% change in revenue and EBITDA. Also, more than 95% of its debt is denominated in U.S. dollars, which drives a lower aggregate cost of debt for the firm. The firm is able to fund its U.S. dollar debt payments from its domestic cash flow, so it does not have to deal with repatriation issues on currency moves. In addition, all of the firm's international contracts have price escalators that are tied to the local inflation rate, so American Tower is not exposed to regional CPI volatility.

REIT Structure May Limit Reinvestment
American Tower's real estate investment trust structure will not constrict its ability to expand its business. Only the firm's U.S. and Mexican towers (roughly half of the firm's total tower base) are underneath the REIT umbrella and thus forced to distribute 90% of taxable income. Most of the company's international operations as well as the network development segment are non-REIT and not subject to those distribution requirements. In fact, the dividend represents only roughly 30% of the firm's adjusted funds from operations (AFFO), so the vast majority of cash flows are being reinvested in the business.

American Tower essentially replaced its share-repurchase funds with the dividend distribution, so the REIT structure has had a minimal impact on the cash returns to shareholders.

Carrier Consolidation Threatens Growth Prospects
While mergers and acquisitions among wireless carriers tend to have a negative impact on sentiment for the sector, the actual effect on the economics of the industry is positive. Whether it was the Sprint/Nextel merger, the Verizon/Alltel tie-up, or Cingular acquiring AT&T Wireless, American Tower's postmerger revenue streams increased 25% on average from predeal levels. Ultimately, these mergers are fueled by a need to invest in network infrastructure, and the firms believe it's more effective (and efficient) to do it jointly rather than as stand-alone entities. While we remain skeptical that the rumored T-Mobile/Sprint merger will pass regulatory muster, it is worth noting that American Tower has less exposure to tower overlap from those two firms than its tower peers (only 5% of site rental revenue, with a seven-year average remaining term life).

Attractive Valuation, Visible Growth Profile, Narrow Moat Make Compelling Investment Case
From our perspective, American Tower's shares appear fundamentally undervalued, trading at a price/fair value of 0.91 and 19 times our 2014 AFFO estimate.

We expect American Tower to reach its goal of doubling its 2012 AFFO per share by the end of 2017, while increasing its dividend by roughly 20% per year over that time frame. We expect the AFFO payout ratio (currently only 30% of AFFO is paid to dividend distribution) to steadily expand as the firm burns through its net operating losses through the balance of the decade.

Ultimately, we believe American Tower stands at the forefront of a very moaty industry that is witnessing an unprecedented level of leasing activity from carriers engaged in advanced data network deployments around the world. Not only are the competitive advantages that allow these tower firms to generate economic profits sustainable, but the fundamental trends that underscore the sources of moat are stable, if not improving.

Intangible assets such as the zoning permits needed to construct new cell towers are becoming increasingly difficult to acquire. It now takes anywhere from 12 to 48 months to go through the process. There are also prohibitive switching costs in the industry that make taking equipment off a tower to move to a competitor economically unviable. This is a key reason churn rates remain so low (typically 1% of revenue). Lastly, with the service ring (radius where a cell site can effectively deliver service to mobile devices) shrinking to accommodate higher-throughput requirements, there is clearly a growing need for denser tower footprints and more points of presence, which should support further buildouts.