Description

Telesites is the largest tower owner in Mexico and a spinoff of American Movil.  Telesites was written up twice, approximately one year ago, and both write-ups are worth a read.  I will focus this write-up on what has changed versus what has remained the same since the 2015 spinoff and then share my forward assumptions.  This write-up is based on multiple conversations with the Company, with other Telesites investors (including some VIC members) and conversations with a couple of large AMT holders.  

As of December 31, 2018, Telesites had 15,763 towers and American Tower had 9047 owned towers and 186 operated towers.  

What has changed:

Valuation/Debt Levels/Capital Return Timing…Big Reset of Co-Tenant Expectations:  Telesites’ valuation and debt levels have come down considerably.  At the time of the Telesites spin, the 20x+ forward EV/EBITDA valuation level required an investor to believe Telesites would add towers, rapidly increase co-locations and make progress towards some tax efficiencies – essentially rapidly evolving into a LATAM AMT 2.0. The actual tower builds were not far from expectations, or even slightly ahead in some cases, but the co-tenancy ratio fell far short of spinoff guidance.

At the time of the spin, the company claimed it could reach a co-tenancy ratio of 1.5-1.6x by 2020.  After speaking with Telesites, it seems that there was little analytical rigor behind their guidance.  They essentially took AMT’s international tenancy ratio (the Mexico only ratio wasn’t disclosed) and said “we’ll do a little better than that.”  In its defense, Telesites was likely counting on more aggressive investment by Telefonica and AT&T. Telesites says the former has done little and has periodically been rumored to seek a buyer for its portfolio.  AT&T has invested since entering the market, but apparently the company more recently has been spending more on marketing versus expanding its coverage rollout. Perhaps both companies are simply pausing after the Mexico presidential election and waiting to see the regulatory fallout before continuing their spend.  In AT&T’s case, the pause could be related to its debt paydown following the TWX acquisition.

The other big source of co-tenant demand was expected to come from wholesale-only wireless network announced as part of the public/private Red Compartida initiative, operated by the ALTÁN Networks consortium  The government essentially gave away a large chunk of valuable 700 MHz spectrum with the expectation that the network would ultimately cover ~92% of the total population by 2024 (including 50 percent by 2020).  There are considerable doubts about whether these targets can be achieved but even moderate progress would likely imply a substantial improvement in co-tenants.

With 90%+ incremental margins, a lower co-tenant ratio is a big deal.    That said, given the considerable tower additions, EBITDA growth, debt paydown and valuation compression, investors can now do reasonably well with no valuation improvement and/or little progress on co-tenant ratios, especially considering capital return is likely coming within the next year.  Should some of the original spin hopes (co-tenant ratios reaching 1.5, possible conversion to REIT, and/or accretive expansion beyond Mexico), Telesites could compound at 20%+ rates.

New Mexico President:  There are more macro related concerns with all Mexican stocks following the election of left-wing president Andrés Manuel López Obrador (AMLO).  For tower companies, however, it seems more likely (but not assured) that any policy with respect to the telecom industry would more likely than not to be favorable towards the tower players.  At the highest level, cell phone coverage is abysmal in Mexico and most programs to encourage further coverage are more likely to adversely impact network operators versus tower companies. This is especially true for Telesites given its substantial exposure in rural areas of Mexico, where the new administration seems particularly interested in expanding coverage.

What has remained the same:

Need for Infrastructure Investment:  There is still a tremendous need for infrastructure investment, assuming Mexico wants to catch other developing markets, let alone move closer to those in the developed world.  We included a link to a recent GSMA report on the LATAM mobile market. The entire report is worth a read, but one chart shows that Mexico lags other LATAM markets on mobile penetration, smart phone penetration and 4G penetration - especially so on a 4G basis.  According to GSMA, Mexico needs to add another 40,000 base stations by 2020 to keep up with rising demand – Mexico has a little over 31,000 towers currently. Given the huge need to expand 4G coverage, it is likely that Mexico is years away from more substantial 5G rollouts.  

https://www.gsmaintelligence.com/research/?file=26d3b58c5ef4fa27930c973feff2d9ff&download

Source:  GSMA

It is also abundantly clear that Mexico has far larger population per tower ratios and lower SIM penetrations levels than other LATAM peers with levels far behind more developed countries.  

Source:  TowerXchange

Towers are still a great business: This is still a great business.  Tower companies have quite the little racket; their customers have to pay for most of the tower equipment as well as the entire ground lease on a pass-through basis.  Tower companies also receive contracts with annual escalators. Telesites’ EBITDA margins are currently over 60 percent and likely are headed towards 70 percent over the next several years.  In Telesites’ case, contracts are tied to the Mexican CPI Index and this inflation escalator does provide some comfort to non-Mexican investors who might be concerned about the AMLO/Peso risk.  The below Federal Reserve data gives the annual inflation data for Mexico. The ground lease and operating expenses should also increase at roughly the same rate as the CPI index and the ground lease is completely passed on to customers.  

Source:  Federal Reserve Bank of St. Louis

Carlos Slim concerns:  Slim still controls the company, owns a large percentage of the illiquid float and there are risks to the minority shareholders.  Many were concerned that Slim’s heavy ownership would discourage other carriers from co-locating on Telesites tower – while co-tenants have disappointed, it is tougher to lay the blame solely on Slim’s ownership levels.  There are further fears that Slim could lead a take-under or that Telesites could overpay for American Movil’s tower portfolio in other countries. Mexican regulation forced the divestiture of Telesites – we’re sure that Slim would prefer not to share his towers with any other carrier and continue American Movil’s monopoly.  But, it seems nearly impossible for this deregulation to be reversed, especially with this administration.

Acquisitions of other tower portfolios at inflated multiples could destroy value.  But, Slim does own ~59% of Telesites and therefore has an economic incentive in Telesites’ success. Tower companies will always trade at significant premiums to traditional telecom firms and Slim is undoubtedly aware of the value created by US tower company acquisitions.  This value could accrue to Telesites’ shareholders if deals are structured/executed well, but many will be apprehensive about international expansion. As Telesites trades at a considerable discount to other tower names, we think it is more likely that Telesites looks to return capital as net leverage goes below 5x by the end of 2019.  

Some of the Telesites investors we have spoken with have spoken favorably about the track record of other company minority investors investing alongside Slim, but Morgan Stanley (among others) has detailed a more mixed record (Grupo Sanborns, Grupo Carso, Embratel, Net Serviços, Telmex International).  When we questioned Telesites about these corporate governance fears, they simply state that any deal would require approval of its independent directors. Capital return (which we believe could begin within the year) would not eliminate the above fears but would certainly help. It should finally be noted that past press reports have suggested that Slim was potentially looking to sell-down a portion of his Telesites stake.

Gerardo Kuri Kaufmann Concerns:  Telesites still has a young CEO whose English is a little spotty.  We have not met Kaufmann, but have spoken with several Telesites and American Tower investors who have.  The reviews have been mixed but probably more negative than positive. Tower-focused US investors looking for a polished US style CEO seem to have been disappointed.  Defenders claim Kaufmann is smart and very capable. After listening to several sell-side analysts repeatedly ask Kaufmann to repeat what he just said, including whether Kaufmann said 2019 tower additions would be “1800” or “800” new towers (it was the former and was probably double expectations), we can sense a “lost in translation” problem.  We would note that Telesites has grown EBITDA at a 16% CAGR rate over the past 3 years and margins have generally exceeded expectations.

Telesites Can be Undercut in Urban Areas:  Telesites can still be undercut by AMT and others in more urban markets.  As part of Mexican telecom regulation, Telesites must offer carriers the same rate that American Movil currently pays Telsites.  Given the enormous incremental margins from a second tenant, AMT and others can undercut Telesites on price in more urban locations.  Telesites does have substantial urban exposure (roughly 55% of its base), and it claims that its premium locations will eventually ensure demand for its towers even at higher prices.  Some Telesites shareholders have suggested the company could actually get around the Mexican regulation by offering a side letter to carriers for select towers. The problem is that T/ALTAN/others would not want contracts for single tower sites but would instead want (lower) rates over a series of sites – something Telesites would not want to do given their confidence in the value of their more premium locations.  A couple of AMT shareholders have told us that their biggest concern with Telesites is that it will take far longer (if ever) for other carriers to expand into more rural parts of the country. Meanwhile, AMT will keep picking-off co-tenants in urban locations and reap the benefits of the high incremental margins. This is not a completely invalid concern. That said, the sheer need for additional tower assets across the country combined with some premium locations and possible AMLO intervention to encourage rural rollouts suggests that Telesites can improve its ratio even if AMT/others achieve a higher share of incremental wins.  Additionally, Telesites current valuation likely requires only limited success to provide substantial upside.

Projections:

A couple of notes on assumed model numbers.  Telesites has guided for 1,800 additional towers in 2019 and has indicated that American Movil will also add a good number in 2020 (we assume 900) but has less visibility beyond 2020.  In our mind, one of the major risks to Telesites is essentially that all other carriers give up on challenging American Movil. In a less competitive environment, perhaps American Movil sees little need to improve cell phone service despite the heavy need for towers across the country.  Currently, AT&T and Telefonica have been less aggressive on buildout and ALTAN’s customer take-up rate has been slower than planned, increasing concerns about its long-term financial validity. American Movil responded to its competitors’ investment slowdown by essentially doubling the number of planned towers.  Perhaps this decision was partially motivated by political considerations, but it is undoubtedly positive for Telesites yet has been greeted with a yawn from investors.

Telesites’ updated co-tenant guidance stood at 1.2-1.3x by 2020 (versus 1.14x at the end of 2018), but given the AM’s larger than expected tower build, it is likely the ratio is closer to 1.2x.  Longer-term, if other carriers expand coverage or ALTAN simply comes close to its coverage outlook, a 1.5x ratio, more in-line with other developing markets, is certainly not unreasonable and Telesites would likely be a home-run from current levels.  But, given likely organic AM tower growth, investors can still do well with more modest improvement.

The average Telesites towers can handle 2.5 tenants while the newer regular towers can handle 3 tenants. It should be noted that of the 1800 towers that Telesites has guided for in 2019, 600 are lower cost Guyed towers which are single tenant towers, with a cost to update of roughly 15 percent per tower.  Regular towers cost approximately 1.5Pmm per tower and lower cost towers roughly 50 percent of this total (with the lower cost towers generating 30 percent lower revenue per tower). Telesites does not know if AMT will request lower cost towers in the future – we assume a small amount continues. Telesites argues there is essentially zero maintenance capex in its business and that a new tenant can be connected in under two weeks.  Based upon conversations with other Telesites shareholders, we assume maintenance spending of 3 percent of sales – certainly there will be some spending if the guyed towers are upgraded – despite Telesites claims that this number is too high.

Telesites’ cash tax calculation is confusing to say the least.  Sell-side estimates are inconsistent, and we’ve received different answers from various Telesites shareholders about how to calculate this number.  After multiple emails/phone calls with the company, we think our estimates are closer, but we could still be a bit off on the calculation. The short version is that Telesites’ tax depreciation schedule does not match its income statement deductions (American Movil’s transfer of towers to Telesites was essentially a gift and Telesites has to assume lower values in the tax depreciation schedule).  We assume 1.45mm per historical tower and a 20-year life to derive fiscal (tax) depreciation estimates which are roughly half those on the income statement. Additionally, Telesites has to add-back the inflation adjusted net monetary liability to its taxable income (essentially net debt multiplied by the inflation rate). In effect, Telesites can only deduct the above inflation portion of its debt cost.  These tax rules do negatively impact leveraged equity returns and this should be considered when thinking about Telesites multiple relative to other tower companies.

Of course, if Telesites can find a way to convert to FIBRA (Mexican REIT), there would be considerable multiple upside.   When we asked Telesites about this last point, Telesites noted that FIBRA status for a tower company might be doable but it is far from guaranteed.  They are still studying this and will have more to say over time. While the AMLO administration policy might help certain parts of Telesites business, we think it is more likely it could be a substantial roadblock here and shareholders should not assume this conversion is a layup.  

Assuming no dividend/buybacks and no incremental debt, we project Telesites run-rate metrics look something like the following:

But, as noted, Telesites reiterated to us that it plans on maintaining leverage levels closer to 5x and said it will provide an update on free cash flow uses by the end of the year.  We believe a dividend is likely (share buybacks are even more accretive but given Slim’s ownership levels, dividends are far more likely). It is unlikely that Telesites will utilize all free cash flow and incremental dividend capacity towards a dividend – at least initially – but the following shows the enormous payout capacity even assuming co-tenant ratios far below other markets.  

Certainly, there is considerable question on how Telesites will be valued – few investors at the time of the spin would have foreseen its EV/EBITDA ratio falling towards 13x current year estimates.   Certainly, bulls can argue that it is unlikely that Telesites will continue trading at such a wide discount to US peers:

Source:  Morgan Stanley

We think tax disadvantages, AMLO/Mexico concerns and some corporate governance worries warrant a discount.  We think one can also question the sustainability of the US tower company multiples. That said, it is certainly possible that further improvement on co-tenant ratios or perhaps even more favorable sentiment towards Mexico/emerging markets could drastically improve targeted IRRs even assuming still considerable discounts to American peers.  

While Telesites is unlikely to be a seller, certain historical tower transactions suggest that investors are overly discounting Telesites shares.  

Source:  TowerXchange

In summary, we think the risk/reward is favorable given the need for infrastructure investment, the significantly lowered valuation/debt levels and the likelihood that Telesites starts capital returns soon.  Greater than expected progress on co-tenant ratios, corporate structure changes and/or a more favorable view of Mexico/emerging markets could allow even greater upside. We acknowledge the Slim/minority shareholder risk and acknowledge a “Waiting for Godot” risk associated with the timing of more rural rollouts as well as emerging market concerns associated with Mexico/Peso.  In our opinion, these concerns are overwhelmed by the large amount of free cash flow that Telesites is likely to generate over the coming years as well as near certainty that 4G continues to be rolled out across Mexico as the secular growth in data consumption continues.

Risks:

-AMLO/Peso/Emerging market concerns

-Slim/corporate governance risks

-Delay in ALTAN rollout/investment freeze in Mexico

-Expensive/Poorly structured international deal

-Delay in capital return

Catalyst

-Progress on Co-Tenant ratio

-Capital Return 

-FIBRA/REIT conversion