An oft-overlooked opportunity in the telecommunications and REIT sectors is cell tower companies.
Every phone call you make, every text message you send, every action you take on a phone app, every internet search you undertake – did you ever stop to think how the information you send (along with the information sent by the other 225 million people in the US with cell phones) is transmitted to the recipient?
A very large chunk of this information is relayed through cell phone towers owned by one of the three largest cell tower companies in the US – SBA Communications Corp (SBAC), Crown Castle International (CCI), and American Tower Corp (AMT). These companies enjoy a virtual monopoly in this space – together they control almost 80 percent percent of the cell towers in the US.
Cell companies historically owned their own towers, but as the industry has evolved, the large cell phone companies found it more efficient to lease from common towers owned by third parties. SBAC, CCI, and AMT evolved in the early and mid-2000s to meet this demand.
I own all of these stocks. My thinking when I purchased these stocks (in 2012 and subsequent years) was that cell communications were exploding as everything moved to mobile. I knew that all that mobile traffic has to go through cell towers, so I thought there might be an investment opportunity there. I started researching who owns the towers, and identified these three companies as the industry leaders.
These companies are organized as REITs, although the only thing they sell is tower space. People frequently miss the REIT classification, because they are often grouped with telecom companies (even my broker classifies them this way, which makes my portfolio look on paper like it is heavy on telecom stocks and light on REITs).
These companies offer the advantages of REITs, but they are not susceptible to the Amazon online retail threat, because Amazon does not (at least for now :)) sell space on large cell phone towers.
I have not sold any of my holdings. These stocks have been good investments for me, and I plan to acquire more shares in each of these companies as time goes on. However, the stocks are currently overvalued, and they are not without risk going forward.
Reasons to Buy These Stocks
More than 92 percent of adults in the US own a cell phone. These folks are doing more and more on their phones every day, as people continue to migrate away from desktop and laptop computing.
Over 2 billion people worldwide own a cell phone, and the international market for cell phones continues to grow by leaps and bounds.
Virtually every one of the trillions of daily actions on all of these cell phones must be routed through a cell tower. Without the cell towers, cell phones would not function as web browsers, communication devices, social media access points, endless fonts of information, etc.
Most tower companies lease or rent out their towers to cellphone carriers with long-term contracts (many as long as 10 years).
These cell tower companies have been growing quickly, as cell data usage has exploded in recent years. Industry analysts have suggested that mobile data usage will continue to grow at a 45% to 47% Compound Annual Growth Rate (CAGR) over the next five years. The continued growth in data usage will require more and more cell network capacity and more wireless sites, and while the growth in these companies is expected to be modest over the next few years (probably 3 percent or so per most estimates), overall the outlook for these companies is very favorable going forward.
The largest companies are continuing to expand from organic growth in data usage. They also grow as they acquire smaller companies in this space, and as they establish themselves overseas. Their growth is augmented by large tower antenna upgrades across the country to accommodate newer technologies and more bandwidth.
These companies have some structural competitive advantages. First, due to high costs associated with moving equipment from one tower to another, the cell companies rarely relocate to another tower. Additionally, these tower companies have a virtual monopoly and have been able to secure very favorable lease terms from the cell companies. Also, as mentioned above, leases tend to be very long (several years on average), with clauses that increase the rent every year. This means that revenues can generally be forecast with some certainty in the near term future. Finally, as mentioned above, cell usage is increasing by leaps and bounds, especially overseas. Unless the cell carriers go to an entirely different model (possible, as discussed below, but this will likely take years), there will continue to be high demand for cell tower space.
Reasons Not To Buy These Stocks – Risks
No investment is without risk, and these stocks are no exception. There are only four main clients for these companies (AT&T, Verizon, T-Mobile, and Sprint). Thus these companies are subject to risk that the cell industry will further consolidate (recently T-Mobile and Sprint canceled their proposed merger, which no doubt caused a sigh of relief in cell tower boardrooms). These risks are actually disclosed in their 10-K statements.
Even if the cell companies do not consolidate, they are partnering with other cell tower companies outside of the “big three” to build their own towers. AT&T and Verizon recently partnered with a new player to construct new cell towers, citing the need to reduce operating costs and the need for “an alternative to the traditional tower leasing model.” This move may simply be a “shot across the bow” of the tower companies, to get them to change their leasing and pricing models. But it could also be the start of a new paradigm, which leaves the big three tower companies standing on the sidelines or radically changing their business models.
Cell tower companies need to be careful that they don’t kill the golden goose here, insofar as leasing revenue increases to the tower companies have generally exceeded subscriber revenue increases to the cell carriers. This is unsustainable and the carriers have been vocal about their displeasure on this issue for the few years.
In addition, each of these companies carries significant debt. This debt is primarily being used to finance new towers, improve existing towers, and acquire new tower sites. But the debt requires cash flow to pay it, and if cash flow is reduced due to four companies suddenly becoming three (or two), or due to leasing contracts being canceled as the cell companies build their own towers or partnering with other companies, the “big three” tower companies could find themselves in worsening situations within the next few years.
Recently there has been political talk of nationalizing the 5G cell system. This development poses an unknown risk/opportunity to the status quo, including to these three main industry players. Details are sketchy, but it is not unreasonable to assume that revenue to these companies could be reduced if the government creates a parallel system. However, existing infrastructure may be used for part of any nationalizing effort, which could certainly provide steady revenues to these companies going forward.
The technology in this space advances with surprising rapidity. For example, the cell carriers have begun using smaller cell antennas (“small cell nodes”) in high population areas. As these small cells become more common, the “large leasing towers” model could become less profitable or obsolete, although large antenna upgrades could combat this trend.
To ameliorate risk, and perhaps diversify within this industry, an investor might consider buying all three of these companies. This is what I did in 2012 when I bought these three stocks. Each has a different slice of the industry, and each looks to fill a unique niche going forward.
Along with everything else in this market, these stock valuations are high right now. I have briefly summarized the business and financials for each of the companies below.
Remember that because they are REITs, the PEs for these companies are very high, and thus this metric is not very useful in valuing REITs. This is because “earnings” for a REIT appear much lower on accounting statements due to the reduction of non-cash charges (like depreciation and amortization) from earnings. The low earnings create a distorted PE ratio, because the earnings are artificially low due to these accounting conventions. The actual cash that flows from a REIT will be much higher than the “earnings” on the financial statements.
A better metric for valuing the current price of REITs is to use “Funds From Operations” (FFO), and a refinement known as “Adjusted Funds From Operations.” Neither of these are GAAP measures, and thus they do not have to appear on the firm’s financial statements.
The ratio between Price and Funds From Operations (P/FFO) or Price and Adjusted Funds From Operations (P/AFFO) can be used as a substitute for the P/E ratio for non-REIT stocks. FFO is derived by adding net income, depreciation, and amortization, and then subtracting out gains on sales of property from the REIT. AFFO is derived by adding rent increases to the FFO, and then subtracting capital expenditures and routine maintenance amounts.
Basically the FFO and AFFO are giving you a more accurate measure of the cash flow in a real estate business, which you can then use as an “earnings” substitute to properly value the REIT against the current price, and to compare different REITs. Again, however, these are not GAAP measures and thus may not be not as precise of a metric as the PE ratio.
Because they are non-GAAP measures, it is not easy to find updated FFOs or AFFOs for REITs. The companies will usually include FFO in footnotes to their financial statements. But you can do these calculations yourself from the income statement. Also, the National Association of Real Estate Investment Trusts provides a very helpful REIT Index, and within the index you can find this data for any REIT you are researching.
The P/FFO statistic can roughly give you an expected rate of return on your investment. For example, if a REIT has a P/FFO of 15, your expected rate of return would be 6.67% (one divided by 15).
Ideally, I want to purchase REITs with two criteria – high dividends, and a P/FFO of less than 20 (which roughly equates to an expected 5 percent return). I have included the dividend yield and current estimated P/FFO for each of the companies below. In this sector, I might consider sacrificing a bit of yield due to the continued growth of these companies, but I would not stray from the upper limit of a 20 P/FFO ratio.
American Tower Corp (AMT)
AMT is the largest of the three companies, and has the most international exposure. More than half of its tower sites are outside of the US, and it is continuing to expand into countries like India, with its large population and increasing cell phone usage. The large international presence lends some uncertainties to AMT’s future, as income could fluctuate due to currency values and other factors.
Including dividend reinvestment, I currently own 90.74 shares, which are worth about $13,400. The current price is $148.34, which means my investment is up over 50 percent in total since 2012.
The PE is 55.2, but remember we don’t focus on PE ratios for REITS. The P/FFO ratio (estimated based on reported 2017 financials) is roughly 22. Dividend yield is 1.93% (currently .70 per share).
Morningstar currently believes the stock is overvalued, and I agree. Their target price is $125 per share, which equates to a P/FFO of about 19 using 2017 financials.
Crown Castle International (CCI)
Like American Tower, CCI is structured as a REIT. After AMT, it is the second largest cell tower company in the U.S. In contrast to AMT’s international focus, CCI has been focusing on its US business, particularly on small cell nodes. They also have tens of thousands of miles of fiber cable for lease to customers. Their management has been specifically focusing on US growth arising from the deployment of 5G technology. CCI owns AT&T’s legacy towers, and thus the recent award to AT&T of a contract to build out an emergency network to reach first responders (FirstNet) should greatly benefit CCI going forward.
Current price is $112.025, and I own 77.9 shares (including dividend reinvestments) for a total value of over $8,700, a 163.51% increase on my original investment (including dividend reinvestment). I wish I had bought more!
The current price is near the 52 week high for this stock. Dividend yield is 3.82%, which is lower than when I purchased because the price has significantly increased. The P/FFO ratio is roughly 25. Morningstar rates the company a buy at $100, which would be a P/FFO ratio of roughly 18 using 2017 financials.
SBA Communications (SBAC)
The third largest U.S. tower company is SBA Communications. The company is focused on the US and Canada, but they also do business in Central and South America. They are a degree of magnitude smaller than AMT and CCI, but they are growing steadily.
The company restructured as a REIT last year, but they are using pre-REIT losses to stave off dividend payments until at least 2020.
I purchased my shares in one time in 2012, paying $70.43 for 33 shares (total paid $2,324.19). I did not have the capital to purchase more shares, but again I wish I had somehow scraped it together. My investment is up 146.7% since my purchase, and is currently worth $5,758.50.
The current P/FFO is roughly 26. Morningstar has a target price of $125, which would be a P/FFO of roughly 19 based on preliminary 2017 financial results.
Together my holdings in this sector are worth roughly $28,000, which represents roughly 7.5 percent of my dividend stock portfolio. Despite the risks, I am holding on to all three for the foreseeable future.
I don’t think they will grow as quickly as they have (as mentioned above, industry analysts forecast slower earnings growth in the range of 3 percent for the next year or so). But the increased demand for “small cell” local networks, continued organic increases in data usage, the new 5G network, and the new public emergency network bode well for the future. If the companies reach their target prices, I will add to my positions assuming I have the investment capital to do so.
As always, I’d love to hear from you in the comments. Do you own these stocks? What do you think of these companies going forward? Thanks and happy investing!