Description

Intro:

Telesites is the largest owner of wireless tower infrastructure in Mexico, and was recently spun out of Telcel the largest Mexican wireless company.  At current price levels we believe there is at least 65-70% upside over the next 6-8 quarters in Telesites stock, as the company steadily grows revenue and delivers strong profits. Furthermore, we believe the stock could rerate higher in 2H18 as the company begins to discuss an initial dividend strategy and a potential REIT conversion in early 2019.  If a REIT conversion occurs, the stock could be worth 24-26 pesos, resulting in up to 100% upside over 6-8 quarters. The stock should generate excellent risk-adjusted returns from current levels and is trading very cheap to undemanding 2019-2020 FCF estimates.  

Company Overview:

The separation of Telesites from its parent Telcel was mandated by the government to spur competition and allow Telcel’s peers to use its wireless assets. The separation was supported by Telecel’s largest competitors, most of whom had expressed interest for many years in using Telesites’ network of underutilized towers. Both Telcel and Telesites are controlled by Carlos Slim, who owns 48% of all outstanding Telesites shares.  

Just like the US six years ago, Mexico is beginning to convert from 3G to 4G and this is expected to drive rapid smartphone adoption and more data consumption, as the cost of data drops and transmission speeds increase.   At a high level, SITES is a pure play on wireless infrastructure in a market that is poised for rapid cellular data traffic growth (but without the volatile retail exposure). 

Telesites controls over 54% of the cell towers in Mexico and is expected to have ~16K towers across the whole country by the end of 2017, while the #2 player (American Tower) will have ~9K towers and other players will have ~4500 combined. The bulk of the new tower capex in Mexico will be driven by Telesites and American Tower over the next 3-4 years.  Telcel (America Movil), Telefonica and AT&T Mexico are the three biggest wireless players in Mexico with over 98% market share, as of 2016.  Though mobile phone penetration in Mexico is 90%, smartphone penetration is 35% and primarily limited to the middle class and wealthy in tier-1 cities.  With the roll out of 4G in Mexico, faster data-speeds will justify upgrading to a basic smartphone for more people, especially as the cost of data declines and smartphones are more commonly used for everyday tasks.  This is similar to what happened in the US and China over the last 5 years.  In particular, as more economic activity migrated to mobile devices, data volumes exploded, creating huge demand for wireless capacity and the associated infrastructure.

New Opportunity:

Until recently, there was an expectation that SITES would have only a modest opportunity to increase its tenancy ratio in Mexico, as carriers took a restrained approach to capex due to recent price wars. It was expected that SITES could lease-up its tower foot print from a tenancy ratio of 1.01 to 1.3 over +5 years in Mexico. While the bulk of the company’s profit growth would come from opportunities in Costa Rica, Columbia and Brazil.

However, the approval of a Mexican public-private partnership called “Red Compartida” in November 2016 dramatically improved the opportunity set for Red in its home market.  Red Compartida (aka “Red”), is a federally subsidized join-venture between a consortium or private investors (Altan Redes) and the Mexican government to create a national 4G wholesale wireless network. 

The goal of Red is to spur competition in a Mexican wireless market that is viewed as insufficiently covered outside of major cities. The Mexican government believes Red will reduce the capex needed by incumbent carriers to expand their coverage and deploy 4G, as the consortium was given access to huge amounts of 700mhz spectrum. Regulators expect access to a reliable and cheap wholesale network will spur competition between new MVNOs and incumbents. All of whom they believe will finally push affordable service out to poorer regions, while making it easier for incumbents to densify networks quickly, spurring economic growth and access to a wider variety of technology services.

The key impact on SITES will be an acceleration of demand for co-locations from a large new customer in its home market. It is believed that Red’s entrance will also spur higher tower demand from incumbents who will move more quickly to upgrade to 4G and increase coverage across the country.  We assume that SITES co-location tenancy ratio increases to +1.3 far more quickly than it would without the creation of Red, and this faster ramp will be the primary driver of the stock price over the next few years.

Notbaly, the monopolization of tower assets by Telcel (now Telesites) has been a massive economic moat preventing all but the largest MNCs from competing against Telcel in Mexico. Evidenced by the fact that only large US and European controlled telcos (AT&T and Telefonica) compete in Mexico today.  AT&T Mexico has been unprofitable since 2014 and cites the large costs of deploying and building their network as a major challenge, especially as Telcel and Telefonica have engaged in price wars for years. But with the creation of Red, the government hopes that local cable companies and other media players will begin offering wireless services quickly.   According to the president of UNITI Tower, companies like Megacable, Google, Walmart Mexico, Amazon and Facebook are rumored to be interested in eventually becoming customers of Red in some form; in fact Red is very similar to Facebook’s “free-basics” efforts in India.  American Tower was also bullish on Red’s prospects and suggested there would likely be many MVNO providers entering Mexico as the new network becomes operational and expands.

The eventual demand for Red’s services seems promising, as there appears to be strong interest from many parties already. Furthermore, Altan Redes has secured financing for the first-phase of Red, expected to cost USD 2.25 billion through 2019.  The ultimate price tag of USD 7-8 billion will be spent on network infrastructure through 2023.   SITES has confirmed they are already co-locating for Red, with an expected pick up in this activity during CQ2 2018.

How many towers does Red need?

Neither Altan Redes or Telesites has quantified the potential demand for towers publicly from Red, but those familiar with the consortium’s plans estimate Red will require at least 13K incremental tower locations in Mexico through 2023.  And of those, at least 11K will be co-located on existing structures, which represents incremental demand of 38% of the current tower base in Mexico.  More importantly, we expect SITES to capture approximately 50-55% of these incremental towers –in line with its current market share, which means approximately 5800 co-location opportunities. However to be conservative we model SITES will capture about 3600 co-locations from Red and another 2800 from AT&T and Telefonica combined, through 2020.

Another metric that highlights the long-term potential demand for towers in Mexico is “number of towers per 1000 mobile subscribers”.  In most markets where a national 4G network has been deployed for at least 3-4 years, this metric is well above 0.5, with the notable exception of the US which is lower due to vast stretches of sparsely populated land.  But in Mexico this metric is only 0.25, while in the US it is 0.41 and in the UK it is 0.71.  This suggests that Mexico could potentially see the demand for towers more than double by 2023, assuming affordability was not an issue.   While this is unlikely due to a high percentage of low wage earners and hence lower USD ARPU, it does highlight the organic growth opportunity in SITES’ home market as the economy grows and data consumption increases quickly.   

Valuation:

My numbers are based on a normalized (pre-growth CAPEX) FCF assumption of 3.5B-3.7B pesos in 2020 at a 18x multiple which is a 15% discount on slower growing US tower REITS such as American Tower and Crown Castle. This would put the stock around 19-21 pesos by mid 2019 and assumes no REIT conversion. I believe the discount to US peers is warranted considering SITES is not a REIT, but still will have much faster EBITDA growth and a long-tail of organic co-location upside, as the Mexican wireless market is many years behind the US.   If we factor in a REIT conversion in mid 2019, then the stock could trade to 27-30 pesos by the end of 2019.  Our base case is for approximately 40-50% upside in 12-18 months.

Other Considerations:

The company benefits from inflation indexed pricing on all its tower leases which resets every year; so it’s well protected from inflationary pressures in its cost base. Furthermore, the company tries to match the average weighted duration of leases on a tower with the duration of the site rental lease (it doesn’t own the land underneath a tower).   Both of these dynamics allow for fairly stable profit margins, and when coupled with 10 year contracts from wireless customers, providing good visibility for investors.

Bond covenants prevent any dividend payments until 2018 and so clarity on pay-out ratios and/or REIT conversion won’t be forthcoming until Q1 18 at the earliest according to management.  This may make the investment case for income oriented investors more challenging until the company starts paying a dividend and has established a track record.

Finally, the Slim family is reportedly shopping up to a 10% stake in Telesites to various sovereign wealth and infrastructure funds around the world.  Unclear whether this block will trade at a discount or premium to prevailing market prices, but it could be well received by investors as the stock may continue to get a “poor corporate governance” discount absent a partial sell-down by the Slim family. New institutional investors would also remove any doubts suggesting Telesites will be run to maximize the value of Telcel to the detriment of Telesites shareholders.  Finally, SITES hasn’t completely abandoned its international ambitions and could make accretive acquisitions in other markets where America Movil operates.

Downside Risks:

The biggest risk to the Telesites investment thesis is a lack of progress on improving the tenancy ratio. Though this would not necessarily result in material down side to the stock, but more likely see the equity trade sideways with a mid-single digit dividend yield (post 2018). A slowdown in leasing activity or a shortfall in the number of co-locations demanded by Red and the big incumbents would likely be the cause of lower than projected tenancy ratio past 2019.  This would most likely be caused by geo-political issues or a recession forcing Telesites customers to pull back from the market.  But aside from these macro issues, the fundamental case supporting higher tower co-location activity in Mexico is quite strong, as the country is still running on a 3G network.

Also, the odds are low that the government will abandon or slow the Red Compartida project as the funding has been raised and the project’s costs are subsidized by the World Bank and the Mexican Government through completion. Furthermore, Altan Redes has secured the rights to some of the best wireless spectrum in Mexico at a heavily discounted price, dramatically shortening the payback period for the private partners. Notably, Red’s progress on the build-out will likely spur existing players to increase their co-location activity or run the risk of increasing subscriber losses as new competitors jump into the market.

However, in the event the market became more concerned about the downside risks, the stock would likely trade to 16x FCF and 18x FFO, which is ~20% below the global peer group multiples. Assuming that these fears were overstated but the multiple discount persisted, the stock would be worth between 15-16 pesos longer term, while paying a very hefty dividend (high-single digit yield).   In the event that the company is not able to increase its tenancy ratio beyond 1.1 and this multiple discount persisted, the stock would be worth 12-14 pesos (while offering a mid-single digit yield).  We don’t believe there is considerable downside from current levels, away from macro risks that would result in sharp multiple compression (NAFTA repeal, Global Recession, etc).

 SITES is trading at a 35% premium to the global peer group on TTM FCF and slightly below the global peer group on a 2018 FCF basis.  With the potential to sustain high-single digit FFO growth organically for several years, SITES will likely trade in-line or better than global peers, many of which can only generate similar returns with aggressive tower-building programs or M&A.  Also, there’s an expectation that local fund managers and retail investors will be attracted to a stock that offers an inflation protected dividend yield that is likely to grow nicely for many years.  That being said, the risk that SITES will trade at a persistent discount to the peer group doesn’t portend a significant amount of downside from current levels as we roll forward 6-8 quarters.

Finally, it’s worth noting that SITES is a bit constrained on using price as a tool grow co-locations, unlike other tower cos in the Mexican market.  This is due to its categorization by Mexican anti-trust authorities as “legal” monopoly.  Presently, its current co-location fees are somewhat higher than other players.  And the government will force it to reprice an entire tower if it offers a potential new tenant on an exisiting tower a lower price.  The reasons for this are illogical and the company is working with regualtors to address it, as they believe this pricing restriction stifles competition, which is at odds with what regulators were trying to do by imposing these rules.  While we don’t foresee this as a major issue due to its leading footprint and ample underutilized capacity, it will likely preclude a sharp ramp in the tenancy ratio that would boost profits more quickly.

Pls see financial model below:                                                                                                                                   

Catalyst

We expect a announcement of a dividend in 2018 and potential conversion to REIT will result in meaningful upside.