What's Not to Like About Wireless Towers?
The business model is fantastic, but the industry isn't risk-free, and interest rate sensitivity could hurt.
The wireless tower industry provides access to fantastic cash flow and exposure to exploding wireless data demand. Long-term contracts and, more critically, high switching costs provide a narrow economic moat despite heavy customer concentration. At the same time, wireless carriers will need to build denser cell site grids to add data capacity, since density makes the best use of advances in wireless technology and higher-frequency spectrum, which has recently shot up in price.
The three publicly traded wireless tower companies-- American Tower (AMT), Crown Castle (CCI), and SBA Communications (SBAC)--dominate the U.S. tower market, making each an essential partner for every carrier in the nation as capacity needs grow.
The tower business is not without risks, however. Major carrier consolidation could dramatically alter long-term demand and the balance of power between tower owners and the carriers. Beyond business fundamentals, capital allocation is a key concern, given the stability of cash flow. Acquisitions have been the dominant use of cash across the industry lately. While this often provides strategic benefits and capitalizes on currently low interest rates, competitive bidding for assets has driven convergence in returns on capital among the three tower companies.
Business Model Creates Narrow Moats, but Not Wide
The wireless tower business is fairly straightforward, which is both appealing and frustrating. The three major tower companies earn the vast majority of their revenue by leasing out space on communications towers they own or control. Contracts with wireless carriers typically run 10 years or longer and generally include escalators that total about 3% annually. Carriers also frequently add equipment to existing sites to upgrade technologies or add antennas to use more spectrum bands. Tower space is priced on weight load and vertical space, so this results in additional rental income.
Thus, tower companies increase revenue per tower in three ways: annual escalators built into contracts, contract amendments with existing tenants, and the addition of new tenants.
To augment this growth, tower companies build a small number of new towers each year, often on request from a carrier, and acquire existing tower portfolios. Acquisitions come in one of two primary flavors: portfolios of sites built up by a carrier or portfolios of third-party sites held by a smaller tower firm. Acquisitions have ramped up sharply in recent years, radically increasing industry concentration, especially in the United States. We estimate that Verizon, AT&T, Sprint, and T-Mobile (the four nationwide U.S. wireless carriers) and U.S. Cellular, which collectively account for more than 95% of the U.S. wireless industry, operate a combined total of slightly more than 230,000 macro, or traditional, cell sites across the country. About 80% of these sites are on towers or rooftops owned or operated by American Tower, Crown, or SBA, up from about 55% at the end of 2012.
This shift in concentration is largely the result of Crown Castle's purchase of nearly 17,000 towers from AT&T and T-Mobile and American Tower's purchase of 11,500 towers from Verizon. Of the major carriers, only U.S. Cellular still holds a sizable tower portfolio, encompassing about 4,000 of the 6,200 sites it operates. The U.S. wireless industry clearly now heavily depends on the three tower companies for a significant portion of the infrastructure needed to serve customers.
Acquisitions have also come fast and furious outside the U.S., especially at American Tower, as carriers in other countries look to monetize their portfolios. However, each of the three major tower firms has taken a different approach internationally. At one extreme, American Tower has been aggressively buying towers outside the U.S. for the better part of a decade. At the other extreme, Crown Castle recently agreed to sell its Australian portfolio, its only non-U.S. exposure. SBA Communications tilts more toward the American Tower philosophy, but its moves abroad are more recent. Despite efforts to diversify geographically, American Tower remains heavily tied to the U.S. market. With the acquisition of Verizon's tower portfolio in early 2015, American Tower still derives about two thirds of its leasing revenue domestically.
The shift to third-party tower ownership makes sense to us. Tower firms can manage towers more efficiently than carriers for a variety of reasons, and independence from a carrier allows multiple carriers to locate on each structure without competitive concern. The tower companies can also leverage their deep tower-management expertise across a far larger number of sites than a carrier can. Also critical, the tower companies pay little in taxes thanks either to real estate investment trust status (in the case of American Tower and Crown Castle) or large net operating losses (SBA). Thus, wireless carriers provide a secure stream of cash flow to the tower companies in exchange for the benefits of access to a large, diverse set of sites at attractive prices relative to the cost and time needed to build infrastructure from scratch.
Switching Costs Are High
In addition to contractual security, high switching costs protect tower revenue, forming the crux of our narrow moat ratings on the tower firms. Equipment is rarely removed from a tower once it's placed into service. In addition to the direct financial cost, moving equipment risks service disruption or changes in coverage that could anger customers. Thus, decisions to remove equipment are heavily deliberated and typically made only in conjunction with a major network overhaul or decommissioning. To illustrate this point, consider that each of the major U.S. carriers continues to operate legacy 2G networks (first deployed in the late 1990s) to ensure that customers with older devices still receive service and to meet contractual obligations, such as those to other carriers for roaming. Carriers take a very conservative approach to network changes.
Also, a large portion of the tower infrastructure now sits in the hands of three companies, limiting the opportunities to leverage one tower owner against another in negotiations. As a result, the odds of finding an acceptable substitute for an existing tower site at a cost that makes switching worthwhile are worse today than in the recent past. Thus, tower companies increasingly compete against new tower construction (again, costly and time-consuming) rather than existing tower sites.
The tower model isn't without its moat-limiting downsides, however. Unlike many other forms of real estate, wireless towers are pretty much suited to a single purpose: radio communications. As a result, tower decommissioning resulting from carrier M&A is the biggest risk facing the tower companies. The acquisitions of Leap, MetroPCS, and Clearwire and the long-awaited shutdown of the Nextel network have limited tower revenue growth over the past couple of years, especially at Crown Castle. We believe the U.S. industry has hit a point of stability that is likely to hold for at least the next couple of years. However, the struggles of Sprint and T-Mobile to reach long-term viability provide uncertainty, since we believe they need to use M&A to create a stronger competitive position. This M&A could take the form of a merger of the two if the political and regulatory environment is favorable after the 2016 election. As a result of this threat, the relative mix of customers served does provide a minor point of differentiation among the three major tower companies. All of the carriers do business with each of the tower firms, but relative exposure varies.
We believe American Tower's customer mix is slightly stronger than its two peers', thanks to a relatively small exposure to Sprint and T-Mobile. If any major consolidation is to happen among U.S. carriers, it will involve Sprint or T-Mobile, putting revenue from these carriers at some risk. SBA also has relatively heavy exposure to Sprint, the financially weakest of the four nationwide carriers. On the plus side, Sprint presents tremendous growth potential thanks to its massive holdings on the high-frequency spectrum. Should Sprint obtain the funding to build out this spectrum, it would need thousands of additional cell sites, presenting particularly strong upside for American Tower, given its low exposure to Sprint today.
Internationally, the threat of decommissioning because of M&A is mixed. In Brazil, the most important non-U.S. market for the tower companies, four carriers hold relatively well-balanced market positions, but this hasn't prevented competitive intensity from escalating, resulting in generally weak margins across the sector. As a result, market consolidation could occur in the coming years, especially if Telecom Italia exits the market to shore up its financial position. The Mexican market looks much more stable, with AT&T acquiring the third- and fourth-largest players in the market. AT&T will invest more in Mexican wireless infrastructure than the firms it purchased could have. The market now has three solid players. India is in the worst condition, with eight players holding at least 5% market share.
Acquisitions Have Taken Center Stage, Driving Convergence in ROICs
Tower companies generate a lot of excess cash. The cost to build towers is largely sunk, while high customer switching costs and multidecade contracts ensure a steady stream of rental revenue. Putting that cash to good use is critical to creating value. Each of the three tower firms has a different approach to capital allocation, but all have one major historical commonality: Acquisitions have consumed far more cash than any of the firms have generated over the past decade.
M&A has fueled impressive growth in sustainable free cash flow, which we define as cash from operations less maintenance capital spending. Each firm has delivered annual per-share cash flow growth in excess of 20% over the past 5 and 10 years.
To evaluate the overall effect of each firm's acquisitions on value creation, we've sought to isolate the capital invested in each firm's tower portfolio and the return those assets deliver while remaining comparable across firms. Our calculation of invested capital uses gross tower and land assets included in the property, plant, and equipment account on the balance sheet. We chose gross rather than net tower assets to eliminate artificial accounting differences among the firms in depreciation rates across what should be extremely long-lived assets. To these amounts, we've added the book value of intangible assets and goodwill, which are nearly entirely the result of tower acquisitions. Including these intangible items eliminates differences in purchase price allocation methodologies and more fully captures the amount of capital each firm has dedicated to its tower portfolio.
To calculate returns, we've used both sustainable free cash flow and adjusted funds from operations. Sustainable free cash flow is cash from operations less maintenance capital spending, as reported by each firm. AFFO is a figure based on the funds from operation calculation typical in the REIT industry, adjusted for straight-line revenue and expenses, maintenance capital spending, stock-based compensation, and nonrecurring items. The primary difference between sustainable free cash flow and FFO is changes in working capital, most notably receipts of prepaid rent, which is often received as reimbursement for tower augmentation spending to accommodate a new tenant.
What we find is that American Tower has lost its commanding lead in returns on invested capital over the past few years as it has taken on a steady string of acquisitions that have diluted its relatively superior position. The recent Verizon transaction continues this trend toward average, in our view. Management expects the Verizon transaction to earn a 7% return on capital five years out, up only modestly from 5% when the deal closed.
Crown Castle has also spent heavily on acquisitions over the past two years, picking up the AT&T tower portfolio in 2013, but this has produced returns at roughly the same level as its relatively low corporate average. SBA hasn't spent as heavily since 2012, and its returns have improved dramatically. We believe this improvement is due in part to the favorable economics of the tower industry and in part to the firm's M&A accounting treatment.
The raw return figures don't tell the whole story, however. Including direct equity issuance and debt assumed, the three firms have spent about $45 billion on acquisitions during this period. Intangible assets have increased from about a third of the total across the industry a decade ago to half today. SBA has spent the most in relative terms, but its reported asset base hasn't grown at a different rate than its two peers--the firm has booked no goodwill over the years, amortizing the full premium it has paid on each of its deals. We believe Crown Castle has taken the most conservative approach to acquisition accounting, allocating a relatively large portion of the purchase prices paid to property, plant, and equipment. As a result, we believe Crown's ROIC figures are somewhat understated, while SBA's are somewhat overstated.
Some may argue that American Tower investors should demand higher returns on capital because of its relatively heavy international exposure. We don't agree, especially over the long term. International markets do expose investors to currency risk and somewhat more volatile local economies. While currency exposure will hurt reported growth in 2015, this headwind could quickly turn into a tailwind. In addition, geographic diversification should reduce volatility over the long run. Network deployments tend to be lumpy by country, and the U.S. is nearing the end of a major upgrade cycle. Furthermore, geographic diversity would reduce the shock from a negative event in any one country--say a merger between Sprint and T-Mobile. With respect to overall economic volatility, wireless service is becoming a basic necessity in most parts of the world and should be relatively stable in the face of macro events. We believe American Tower has produced the most attractive returns historically.
Again, however, the Verizon deal makes American Tower decidedly average. With the massive amount of capital that each of the tower firms has poured into acquisitions, it makes sense that ROICs across the firms are converging. These acquisitions generally follow a bidding process, with each of the three firms keeping the others honest. This is especially true in the U.S., where all three tower firms are active and the largest sales have involved the carriers, which are certainly savvy sellers.
And the Best U.S. Towers Belong to…Everyone
With the tower companies looking decidedly similar on the basis of returns on invested capital, we turn our attention to the strategic positioning of their tower portfolios, especially in the U.S., to look for potential differences in future cash flow growth. What we find are fairly minor differences, especially beyond the next couple of years. Wireless tower companies describe their tower portfolios with a wide variety of statistics, typically intended to demonstrate how great their holdings are relative to other firms. Some examples are the percentage of towers in the top 50 or 100 U.S. markets, the percentage in suburban areas, the number on owned land, the average remaining contract length, and the carrier of origin. We don't find these measures very useful. Ultimately, each tower is unique, and the characteristics that make a large portfolio of towers more or less attractive are not easily quantified.
If we were purchasing an individual wireless tower, the analysis would be straightforward. First we'd investigate the specific characteristics of the tower: the number of tenants on the tower relative to its structural capacity, the terms of each lease, the cost of adding height or capacity if needed, and the ownership position of the land under the tower. We'd then want detailed information about the nearest existing towers (location, owner, height, type) and the topographical variations (hills, trees, buildings) that affect whether these sites would make good potential substitutes. We'd next want to understand how easily a competing site could be built: Are attractive locations available nearby and are local regulatory bodies generally easy to deal with? We'd also want to know the demographic conditions around the tower to garner some insight into future wireless demand.
With this information, we'd form expectations about the ability to add tenants to the tower, the cost of creating space for new tenants, our pricing power in negotiating contract terms, our bargaining power with the owner of the land where the tower sits (if the site isn't owned), and the cost of maintaining the site. We could then project with reasonable confidence the amount of cash flow this tower would produce over the next couple of decades and, based on the level of competitive uncertainty, assign a value to that cash stream.
The publicly traded tower companies own or control thousands of sites in several countries that were acquired at various times, making it extremely difficult to form a comprehensive view of each firm's portfolio. Given the impossibility of analyzing each individual tower and aggregating the results for each firm, we instead rely on the law of averages--the benefits of good sites tend to offset the detriment of bad sites--and look for key financial metrics that can serve as proxies for relative tower quality.
Average monthly cash revenue per tower is the most useful metric, in our view, to evaluate and understand the differences in strategic positioning among the tower companies. Cash revenue is a metric used across the tower industry to adjust for the accounting treatment of revenue escalators. Generally accepted accounting principles dictate that revenue from contracts with fixed-rate escalators be recognized on a straight-line basis, though the cash received early on under these contracts is less than that received later. Cash revenue eliminates this straight-line effect.
When looking at the past five years of and our expectations for average cash revenue per tower and average revenue per tower growth, we see that major tower portfolio acquisitions dramatically reduce average revenue per tower. This change results from the fact that towers in the hands of carriers haven't been marketed aggressively to rival carriers and are generally younger (built more recently) than existing towers. The typical legacy tower in one of the tower firms' portfolios has 2.0-3.0 tenants, while the T-Mobile, AT&T, and Verizon tower portfolios held an average of 1.6, 1.7, and 1.4 tenants per tower, respectively. We believe that paying attention to current growth rates can quickly lead investors to incorrectly favor one tower firm over others.
American Tower has systematically produced more revenue per tower in the past than either Crown or SBA. In part, this gap is the result of American Tower's sizable broadcast tower portfolio, which typically serves radio and television stations. We estimate that these towers generate $40,000-$50,000 in monthly revenue per tower, far higher than the typical communications tower. We suspect that this business explains about half the gap between American Tower and its rivals. In addition, our American Tower figures include small cell and distributed antenna system revenue. SBA isn't in the small cell/DAS business, and Crown Castle provides enough information to allow us to remove this revenue from our calculations.
We believe American Tower has still historically produced more revenue per tower than either of its rivals, but the difference is fairly small and difficult to measure. We suspect this difference was, in part, the result of American Tower's historically relatively more mature tower portfolio. We believe that, on average, older towers will enjoy persistently higher tenancy despite the tower firms' efforts to add tenants to recently acquired properties. Our reasoning is that if a carrier is not already on an older tower, there is a higher likelihood that the carrier has built or located on a newer tower in the area and the older tower simply doesn't fit into its network plans. At the end of 2014, American Tower reported that it had about 2.6 tenants per U.S. tower, while Crown and SBA claimed around 2.3 and 2.0, respectively.
With the Verizon tower acquisition closing in early 2015, American Tower's portfolio mix now looks very similar to its peers based on vintage. With the Verizon assets, American Tower now claims about 2.2 tenants per U.S. tower across its portfolio, comparable with its rivals. As a result, we don't believe any of the tower firms will have a significant advantage in driving revenue per tower growth over the next several years, leading to similar long-run U.S. growth rate assumptions embedded within our fair value estimates.
SBA has produced impressive growth in revenue per tower over the past couple of years after acquiring towers from TowerCo and Mobilitie in 2012. These towers were primarily built for Sprint and T-Mobile, leaving these sites underexposed to AT&T and Verizon. AT&T and Verizon spend far more on their networks each year than either Sprint or T-Mobile, adding new cell sites at a faster clip (especially AT&T over the past couple of years). This has worked to SBA's benefit.
In addition, SBA has refrained from signing larger master lease agreements with the carriers and instead has negotiated lease amendments on a site-by-site basis. With heavy demand for amendments related to the buildout of LTE technology, this decision has worked to SBA's advantage recently. In essence, SBA has used the move to LTE to more effectively monetize the switching costs carriers face than either of its peers. While this has worked out well for SBA, it doesn't necessarily reflect any inherent strategic location-based advantages within its tower portfolio. It is also possible, in our view, that SBA's dealings with the carriers could limit their willingness, at the margin, to use SBA sites for new construction.
In summary, we believe it is difficult to meaningfully differentiate between the strategic locations, on average, of the three tower companies' U.S. macros site portfolios based on current information.
On the cost side of the ledger, land (including rooftops and other fixed structures) represents the most important input in the leasing business, by far, in the tower business model, typically representing around 70% of total operating expenses. For most tower sites, the land beneath and around the tower is leased from a third-party landlord, such as a shopping center owner, farmer, or government agency. As a result, land rights also represent a key risk for each of the tower firms--if a landlord chose not to renew a lease, the tower might have to come down. Or the landlord could demand unreasonably high rent upon renewal. Land (or rooftops, etc.), not the tower structure, is the scarce resource in this business.
To counter this risk, all three tower companies have aggressively worked to buy the land under their towers or extend ground leases as far into the future as possible. The firms don't provide consistent statistics on their land holdings and ground lease terms, but American Tower appears in relatively worse shape than its peers. The firm's site leases are far shorter, and its owned-land portfolio is likely the smallest of the group (its reported owned tower percentage includes sites on capital leases). This position is in part the result of the acquired Verizon portfolio, which included very few owned sites and shorter average leases. American Tower has also spent a relatively small amount to acquire land over the past decade.
SBA holds the strongest land position, in our view, despite spending only moderately to acquire land. A relatively small percentage of the towers in SBA's portfolio were originally built by one of the wireless carriers. Tower companies tend to pay closer attention to land concerns when constructing a tower because carriers are generally more willing to trade a lesser ground situation for a superior strategic location.
Given the small number of expiring leases that each tower firm faces over the next several years, the impact on near-term financial performance resulting from the differences in land positions should be fairly small. Directionally, however, we expect American Tower's costs per tower to increase faster than its peers as it seeks to extend maturities on its leases over the next couple of years. The firm has a stated goal of pushing the percentage of towers it owns or controls for more than 20 years to 80%. Conversely, we expect SBA to enjoy the slowest pace of cost growth.
Densification Drives Demand: Smaller Site Sizes Present Opportunity
Our confidence that the tower firms will be able to drive growth in revenue per tower beyond the annual contractual escalator is based on our belief that wireless networks of the future will be significantly denser than they are today. Wireless network capacity can be added in one of three ways: adding spectrum, reducing the geographic area each cell site serves, or improving signal quality. The first option, adding spectrum, has become extremely expensive after the heavy bidding in the Federal Communications Commission's AWS-3 auction. As a result, the second two options have become relatively more attractive.
In addition, reducing cell sizes and improving signal quality are interrelated and provide compounding benefits. As wireless engineers shifted focus from voice calls to data capacity, a critical development quickly surfaced: adaptive modulation and error correction. All wireless technologies developed over the past 15 years include the ability to adapt the modulation scheme to the quality of the wireless signal. Rather than aim to deliver reliable coverage to all users and nothing more, networks today have the ability to shift to higher-order modulation and more efficient error correction schemes when conditions are favorable. As a result, spectral efficiency (bits transmitted per second per unit of spectrum) improves dramatically as signal conditions improve. The surest way to improve signal quality is to reduce cell sizes, which naturally cuts the number of customers placing demand on any one site.
Wireless technology is steadily evolving to enable the seamless use of multiple technologies, cell site sizes, and spectrum bands to deliver capacity where it is needed. The traditional wireless site (macro cell) serves the purpose of providing network availability to nearly every nook and cranny of the territory it covers. From there, DAS networks and small cells deliver capacity to those locations within the macro cell where demand is the highest or signal coverage is particularly problematic. We expect existing tower infrastructure to be critical in allowing carriers to economically build small enough macro cells to blanket areas with adequate capacity while also providing opportunities to efficiently deploy DAS and small cell equipment in many areas.
Crown Castle has taken the most direct approach of the three tower firms to address carriers' needs for diverse infrastructure on which to deploy network equipment. Its acquisition of NextG Networks in 2012 brought a large portfolio of DAS sites and a pipeline of sites in development. Today, Crown provides service to 14,000 DAS nodes and growing. In addition to DAS infrastructure, Crown has started to tackle network backhaul, one of the key hurdles to DAS and small cell deployment. The firm owns or has rights to about 7,000 miles of fiber optic cable in metro areas around the country. It also recently inked a deal to buy Sunesys, a firm that owns or has rights to 10,000 miles of fiber in Los Angeles, Chicago, Philadelphia, Atlanta, New Jersey, and the San Francisco Bay Area. About 7% of Crown's U.S. leasing revenue now stems from its DAS and small cell business.
American Tower's portfolio also has DAS systems, claiming to control 300 indoor DAS networks in the U.S. and another 125 systems internationally. This business is small, however, probably totaling less than 3% of U.S. leasing revenue. The firm has said that its focus will remain on the macro tower business, with DAS playing more of a complementary role. The issue, as American Tower sees it, is that the economics of the DAS and small cell market generally, but especially in outdoor environments, aren't as favorable as the traditional macro site business as a result of higher costs, more limited colocation opportunities, and technological risk. We agree that DAS and small cell deployments probably aren't as profitable, but we also believe that these assets will hit the sweet spot of future infrastructure demand.
SBA has taken yet a different approach to the DAS and small cell business, selling its DAS assets to ExteNet, a privately held firm, in exchange for an equity stake in 2010. The firm has subsequently sold additional DAS assets, acquired through the Mobilitie and TowerCo deals, to ExteNet for cash in 2012. In July, ExteNet announced a recapitalization that will redeem SBA's stake in the firm.
We believe having a diverse set of assets available, like Crown is building, should spur the carriers to favor working with certain tower firms over others. We expect this benefit to be fairly small, producing only modest incremental growth potential for Crown. But this is still a source of growth from which we expect Crown to disproportionately benefit in the coming years.
Michael Hodel does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.