Description
Thesis
Spectrasite (SSI) is an undervalued post-bankruptcy cellular tower company that is exhibiting tremendous growth and demand characteristics, has a predictable recurring revenue stream with high operating margins, and is producing strong free cash flow. With no principal payments on its debt obligations til 2006, SSI will likely do a “leveraging” transaction to return value to its shareholders (share buybacks or dividends). Additionally, SSI is underlevered relative to its peers (AMT, CCI) making it a likely M&A target for these more highly leveraged tower companies and would deliver significant deleveraging and improved operating cash flow growth to its merger partner.
I recommending taking a long position in Spectrasite Communications (SSI) equity and believe it will provide at a 25-40% return in the next 12-18 months, and potentially higher in 2006 and beyond – continuing its strong free cash flow generation and growth. At $38.25, SSI trades at 14.5x my FY05 free cash flow estimate and has a 6.2% current FCF yield (9% in 2005). I believe FCF per share to grow at 15-20% over the next several years.
Investment Highlights
• Attractive FCF Yield: +6%
• Growing FCF @ 15-20% Over Next Few Years
• Significantly Lower Net Leverage Than Comps
• Concentrated Tower Portfolio in Largest US Markets
• Potential “Leveraging” Transaction: Share Repurchase, Dividends
• Continued Revenue Growth and Tower Capacity Demand
• Highly Predictable Revenue Stream w/ Price Escalators
• High Incremental Gross Margins: +90%
• Low Maintenance CapEx: <10% of Revenues
• Significant Barriers To Entry
• Substantial NOLs: $300+ mm
Description
Spectrasite owns, operates and manages wireless communications towers and broadcast transmission networks. Spectrasite operates in two segments: the Wireless segment -- leasing and subleasing of antenna sites on multi-tenant towers for a diverse range of wireless communication services; the Broadcast segment -- leasing and subleasing of antenna sites for broadcast communication services and broadcast development services, including broadcast tower design and construction and antenna installation. At 12/31/03, SSI owned 7,577 towers and in-building systems, primarily in the top 100 markets in the United States. SpectraSite’s customers include: AT&T Wireless, ABC Television, Cingular, Nextel, Paxson Communications, Sprint PCS, Verizon Wireless and T-Mobile.
Emergence From Bankruptcy
On November 15, 2002, Spectrasite voluntarily filed for Chapter 11 bankruptcy protection. At the time, Spectrasite was highly levered and could not be able to support its capital structure @ ~19x Net Debt/EBITDA.
This primarily stemmed from:
• Overzealous expansion during telecom “bubble”
• Expensive tower acquisitions
• Exposure to low margin, non-recurring ancillary services (leasing business performing well)
• Decline in carrier capital spending
• Overleveraged
On February 10, 2002, Spectrasite emerged from bankruptcy with its management intact – only three months later. Effectively, Spectrasite underwent a debt-for-equity swap.
The “new” Spectrasite”: ~$690mm post-reorganization:
• Management team remains: CEO, COO, CFO
o “New” options of ~5.5mm (10% of fully diluted s/o) issued to management
• “Old” Spectrasite equity cancelled: 166mm shares
o “New” 2.5mm warrants to purchase @$16/share
• Extinguished $1.76 billion of debt
o Converted into ~47.5mm “new” Spectrasite common
o Net leverage falls to ~4x
• Focus on core leasing business
• Divested Network Development Services business
• ~25% Debt/EV
Secondary Equity Offering
On 10/03/03, SSI announced ~$272mm was raised through a secondary offering from its four largest shareholders: Apollo Management, Oaktree Capital, Capital Research and Franklin Mutual. The transaction increased the number of SSI’s shareholders and trading volume, enabled SSI to get listed on the NYSE, and significantly increased SSI’s float. On 2/6/04, SSI announced another secondary offering by selling shareholders of ~$315mm was raised.
Predictable revenue stream
SSI operating model features:
• Long-term contracted revenues with annual price escalators of ~2-5%/year
• Low churn rate of less 2%/year
• Low fixed operating and capital costs
Long-term leases and contracts allow SSI to have a consistent revenue stream with growth and demand characteristics. Typically, a tower lease is between 5-10 years long with built-in renewal options. The prohibitive costs of relocating equipment ensure high renewal rates and a low churn.
A non-broadcast tower costs anywhere from $200-300k to build, depending on the location, type, and height, etc; broadcast tower can cost 2-3x or more. Once constructed, operating costs are mostly fixed while maintenance capex comes to ~$2,000/year, and includes tower maintenance, paint, light bulbs, and generators. Tenants largely foot the bill for all other costs, ensuring SSI pays few marginal costs for additional tenants – resulting in high-margin revenue. As lease rates rise and additional tenants sign on, growth, revenues and free cash flow should increase.
REIT Business Model
While many investors link the tower companies to telecommunications, a less obvious link is to the REITs. Tower companies and REITS are similar in many ways:
• Recurring contractual and high-margin revenue
• Collect rent from its tenants for space on its towers; max of 4 tenants/tower
• SSI generates over 95% of EBITDA from rents
The fundamental differences are:
• REITS dividend out a majority of their FCF, while tower companies use FCF to deleverage
• Tower companies have significant NOLs
• Tower companies FCF is considered riskier, in general
As a result, tower companies should command a higher multiple than the traditional REITs to compensate for the higher growth rate and relatively increased risk.
It is interesting to note, Global Signal (fka Pinnacle Towers) – the 4th largest US tower company – filed for a $200mm IPO on 2/13/04 and has reorganized at a REIT. I believe this IPO will generate further interest and investment in the sector.
* For an explanation on the “REIT Business Model” -- See Blue320’s post on SBA Communications (SBAC) on 3/9/03. Many of the traits for SBAC apply to SSI.
Favorable Industry Trends
Wireless service providers are continuing to invest in wireless networks to maintain and improve network quality. A number of trends are contributing to this:
• Increasing wireless penetration
• Increasing minutes of usage (30-50% growth over the next several years)
• Rollout of 3G and other wireless technologies
Although growth rates in cell site deployment have slowed significantly in the past couple of years, tower industry revenues grew at double-digit rates.
Concentrated Portfolio in Largest Markets
Of the four public companies, SSI has the highest concentration of towers in the top US markets:
• Top 25 Markets: 41%
• Top 50 US Markets: 58% vs. 38% for AMT vs. 51% for CCI
• Top 100 US Markets: 71% vs. 60% for AMT vs. 72% for CCI
I believe these markets will attract a disproportional amount of network investment by the carriers. Given the carrier’s focus on improving network quality and the trend of increased minutes of usage, wireless towers in the largest markets stand to gain the most as expansion, 3G and new technologies will be deployed here first. As a result, SSI should grow the number of tenants/tower and revenues as least as fast as its competitors, if not faster.
Capital Structure
With an enterprise value of $2,369.9mm, SSI’s capital structure consists of:
• $439.6mm bank debt
• $200.0mm 8.25% senior notes
• $252.5mm in liquidity
o $60.4mm cash
o $192.1mm available revolver
Net leverage for the Q4 03 was 3.4x (vs. 7.4x for AMT; 7.7x for CCI) with ~25% Debt/EV.
* SBC tower acquisition not included; expected to be financed thru FCF
Lower Net Leverage/Higher FCF Margin
As part of the reorganization process, SSI was able to extinguish ~$1.76 billion in debt. As a result, SSI has significantly less net leverage than its peers (3.4x vs. 7.4x for AMT; 7.7x for CCI) and continues to pay down debt with its FCF. I am modeling this to drop to 3x by year end 2004. Although no debt obligations are due til 2006, SSI can be completely debt-free - if is so choosed - using FCF and cash on hand prior to 2006.
With a relatively lower interest expense (11% of ’03 revenues vs. 32% for AMT and 24% for CCI), SSI possess significantly higher FCF margin (+35% vs. ~15-20% for its peers). I anticipate SSI to be to grow FCF at 15-20% clip over the next several years.
Potential Share Repurchase/Dividend
Alternatively, SSI could “lever up” by $500mm or more (still only 5.5x net leverage) to pursue various strategic alternatives:
• Stock repurchase
• Special dividend
• Recurring dividend
• Additional tower assets
• Tower acquisitions
As mentioned, SSI has no debt coming due until 2006. I am projecting $115mm (6% yield) in FCF in 2004 and $160mm (9% yield) in 2005. I believe SSI is most likely to use it net leverage position and free cash flow to return value to shareholders in a special dividend, a recurring dividend or a major stock repurchase (potentially from the major shareholders who are liquidating their positions). Without levering up, current debt covenants restrict a dividend greater that $90mm without an amendment. Applying FCF strictly to share buybacks, would result in ~15-20% of shares outstanding to be repurchased.
Potential M&A target
For the past 18 months, the tower companies were focused on getting their own houses in order. SSI is highly desirable for its strong nationwide footprint and net leverage position. Although all the public tower companies are highly leveraged, SSI would provide an opportunity to deleverage given its relatively lower net leverage, as well as provide significant cost-cutting opportunities in overhead and redundant G&A costs. In the current interest rate environment, all of the tower operators have access to cheap capital, thereby potentially sparking a wave of consolidation in the near future. SSI is the only public tower company that can significantly increase it net leverage position. Additionally, SSI may purchase an incremental 447 towers thru August 2004 for a total of $123.2mm from SBC Communications. In all likelihood, SSI will fewer towers.
Substantial NOLs
SSI will most likely not be paying taxes until 2012, at the earliest, and can apply ~$35mm in NOLs/year. SSI has federal net operating loss carry-forwards of $323mm (expire beginning 2012), and state tax loss carry-forwards of $318mm (expire beginning 2004). In addition, book and tax depreciation differ by ~$40mm – from the writedown of assets during reorganization, providing additional tax shields and increasing its attractiveness as a M&A target.
INVESTMENT RISKS
• Carrier Consolidation: Continuing consolidation between wireless carriers could reduce demand for towers. SSI anticipates ~3% of recurring revenue to be lost from the AWE/Cingular merger. Given SSI’s position in the largest markets, they will be less exposed when compared to its peers.
• Carrier Spending: Carrier spending has been down over the last two years, declining ~20-25% year-over-year. Reduced carrier spending would result in lower investments in cell sites. However, recent trends in technology and wireless usage guard against this.
• Customer Concentration: Like AMT and CCI, SSI generates +80% of its revenue from the “Big Six” wireless carriers. While these are the customers SSI wants/needs to have, it exposes them to the whims of the industry. Nextel (~30%) and Cingular (~20%) are SSI’s largest customers and are expected to invest significantly in their wireless networks over the next several years.
• Leverage. SSI possesses a high level of leverage, although relatively less than its peers. Any significant downturn in the industry or the loss of a major customer would severely inhibit SSI’s ability to service its debt.
• Land ownership: SSI owns ~5% of its land rights vs. ~20-25% for AMT and CCI. If SSI unable to renew and/or extend its land leases or acquire more of its land rights, then it could be forced to remove revenue producing towers.
2004 Guidance (midpoint)
• Revenues: $339mm
• EBITDA: $180mm
• Interest: $39mm
• CapEx: $33mm
• FCF: $108mm
• FCF/share: $2.27
* Does not include potential SBC tower acquisition.
Valuation
SSI is currently trading 14.5x my FY05 FCF estimate (vs. 15-17x for its peers) and possesses a 6.2% FCF yield, growing to 9% in FY05 and 11% in FY06. Also, SSI trades at ~210k/tower vs. +$315k/tower for CCI and AMT. As carriers roll out 3G, new wireless technologies and high speed data networks, SSI should benefit directly and continue growing FCF at 15-20% over the next few years. As costs are largely fixed, small increases in revenue results in large positive swings in FCF and earnings.
Conclusion
Eighteen months ago, all of the tower companies (SSI, CCI, AMT, SBAC) were highly levered and on the brink of bankruptcy. With high debt-to-equity ratios, this may have been the real opportunity as there was so much "whip” in the equity value: a 1.0x turn increase in multiple creates a lot of equity value – essentially public LBOS. While the tower stocks have had an incredible run, I still find the industry, and specifically, Spectrasite (SSI) compelling at current levels.
Catalyst
• Continued Revenue Growth
• Potential Share Repurchase
• Potential Special Dividend
• Potential Recurring Dividend
• Potential M&A Target
• Ratings Agency Upgrade
• Further Deleveraging
• IPO of Global Signal
• Purchases of Land Rights Near Tower Assets
• Possible conversion to REIT structure