Towers of Babble - Preventing the cellular tower industry from toppling

Dec. 29, 2003 10:16 AM

Towers everywhere, but who owns them and how? We take a look into the world of the REIT.

It's not just the network and phone manufacturers who are making it big with wireless. All of those transmitter towers have to go somewhere, and a whole raft of companies specializing in locations to put those towers have sprung up. This is a completely new business, with no precedents or business models to go with it, or is it?

When is a cellular tower company not a cellular tower company? When it's a REIT.

The typical REIT (Real Estate Investment Trust) is a real estate company that develops, acquires, owns, manages, and sells income-generating properties like apartment buildings, office buildings, and shopping centers. By law, a REIT, which does not pay taxes at a corporate level, must distribute 90% of its taxable income to its shareholders every year. Cellular tower companies and REITs share many similarities:

A cellular tower company owns, manages, and develops properties (the towers and sites) that generate income, and it often distributes dividends (income) to the company's investors/shareholders, just as REITs do.
A cellular tower has a limited number of spaces that the tower company can lease, just as a REIT has a limited number of floors that it can rent in one of its office buildings, or a fixed number of apartments available in one of its residential properties.
Cellular tower companies have lease-paying tenants - wireless carriers and other providers like paging companies - and their long-term success depends on retaining those paying tenants and keeping them happy, just as REITs must do with their real-estate tenants.
In the 1990s, as nationwide mobile telephone use increased exponentially, the major cellular tower companies (American Tower, SpectraSite, Crown Castle, Pinnacle, and SBA) expanded through the acquisition and development of portfolios of towers, just as REITs grew during those good times by adding buildings to their holdings.
Both cellular tower companies and REITs can depreciate their assets, which reduces their taxes and improves cash flow.

Thus, the cellular tower companies are, in essence, glorified REITs serving the telecom market, rather than simply telecom service providers.

Wall Street's Rose-Colored Glasses
Wall Street analysts, however, continue to treat cellular tower companies more like service providers than REITs. In essence, analysts have misclassified tower companies and are using an entirely incorrect set of metrics to assess the current financial stability and long-term sustainability of the industry.

REITs are closely scrutinized by Wall Street, but most analysts don't dig deep enough into the cellular tower industry to examine the real numbers and trends, like growth margins, net occupancy absorption, market value per earnings, and return on equity. If they do consider occupancy, they assume sustainable occupancy projections based on often devastatingly insufficient data.

Not only is Wall Street's myopic treatment wrong, it is potentially harmful to investors. Because analysts don't give them a complete picture, investors can mistakenly sink substantial sums into a company that may not generate sufficient returns, or may be on the verge of eventual collapse. The subsequent recriminations would only further erode the public's confidence in the industry and the stock market.

An Unsustainable Business Model
What would happen if REIT analysts and cellular tower analysts had lunch together and compared notes? What would happen if Wall Street more effectively evaluated the cellular tower companies, some of whose stocks are now trading at or near 12-month highs? The analysts would find that the companies' current business model is potentially unsustainable...and most of their stocks are overvalued.

Trouble for the cellular tower companies started in the late 1990s when they acquired portfolios of sites and developed their own properties at the peak of the telecom market. Most of the acquisition prices and return expectations were based on unrealistic tower occupancy projections and high multiples of expected revenues. If a REIT, for example, was to buy a 100-unit apartment building with the expectation that it would be able to rent all 100 units, the purchase price would be based on the income the 100 rented units would eventually generate.

But what if the REIT was able to rent only 50 units and made up the shortfall of revenue by charging usurious fees for things like curtains, door locks, pool access, TVs, toilet flushing, and the like? The 50 tenants would be very unhappy and look for any opportunity to quickly move to an alternate building. At a minimum, they certainly would not recommend the same landlord to their family and friends.

This is exactly the corner into which tower companies have painted themselves. When the tower companies acquired those large portfolios of sites in the 1990s, they thought they could easily cover their costs with expected rents and high occupancy rates, because the wireless companies were expanding rapidly, and they needed extra capacity immediately. At the peak of the telecom bubble, the carriers were willing to sign tower leases almost regardless of the costs or operating conditions.

But of course, every bubble eventually bursts. The wireless carriers, burdened with heavy debt loads and expensive tower lease agreements, have squared off against the tower companies which, faced with their own high fixed costs and flat occupancy rates, have kept the revenues flowing by continuing to charge high lease rates with annual escalations and raising fees for anything they think the wireless carrier tenants might need, from spectrum restrictions to coaxial cable.

Needless to say, the wireless carriers are mad as hell, and they're not going to take it anymore. The carriers are moving their business away from the tower companies to less restrictive, more flexible occupancies. They're beginning to work with other carriers (Sprint and AT&T Wireless), building and operating their own towers, and using the newest technologies to reap more capacity from less tower space. Virgin Mobile's Virtual Carrier model is yet another alternative strategy taking tenants and badly needed revenues away from the already hard-pressed tower companies.

The performance of cellular tower companies looks particularly shaky when three of that industry's leaders - American Tower (AMT), Crown Castle (CCI), and SBA Communications (SBAC) - are compared to three major REITs - Kilroy Realty (KRC), Equity Office (EOP), and Arden Realty (ARI) - in terms of current market multiples, profitability ratios, and leverage ratios. In 2002:

The average operating margin for the three REITs was 41.30%. The average operating margin for the three cellular tower companies was -15.52%.
The average profit margin for the REITs was 20.73%, compared to -47.73% for the cellular tower companies.
The average return on equity for the REITs was 7.35%, compared to -49.12 % for the tower companies.
The average free cash flow per share for the REITs was $0.47, and -$0.91 for the cellular tower companies.
The average operating cash flow per share for the REITs was $3.39, compared to $0.51 for the tower companies.

Overall, the average market value per earnings for the three REITs was $23.60 in 2002, and -$5.00 for the three cellular tower companies.

None of this reality is being scrutinized on Wall Street, and that's an increasingly serious problem. Analysts must take a different and closer look at the cellular tower industry and its major players. As with any REIT, cellular tower companies should be judged by their rents, tenant retention, return on investment, vacancy/occupancy rates, occupancy as a percentage of capacity, profitability ratios, and leverage ratios, including debt/equity ratios, and operating ratios.

Unfortunately, if the cellular tower companies were immediately held to these REIT-based standards, their position would become even more unstable. Many companies would crash and burn.

The goal is not to kill off the cellular tower companies, but to hold them accountable. For now, therefore, Wall Street and the tower companies should adopt some interim common-sense standards by which they should be evaluated to help them steer through this transition period without sinking under the weight of their current unsustainable business model.

Wall Street, for example, should evaluate the cellular tower companies' underlying economics on the same playing field as that of the REITs. The companies must also return to reality and revise their revenue and occupancy projections accordingly. In addition to adopting these interim evaluation standards, it's time for Wall Street to work diligently to completely understand what it will take to make wireless carriers happy and continue as tower tenants.

The wireless industry, despite its current travails, is here to stay and should grow significantly over time. For the foreseeable future, it needs towers, so the cellular tower industry is also here to stay, but not in its current unsustainable form. Its survival depends upon it making some fundamental changes, and on the carriers and Wall Street.

I, for one, don't mind an occasional additional fee from my cable company, but charging me to turn on the TV? Come on, even I would look for another provider.

About Gary Jabara